me.I decided to use a three-minute price ränge äs my version of the minimum trend. The next step was realizingthat a number of minimum trends could be grouped statistically to form a bell curve. I came up with the idea thatthe bell curve could be used to represent an arrangementof behavior around price. The first Standard deviation —the middle of the bell curve, where the majority of activitytakes place—would represent value, while the second andthird Standard deviations would measure price away fromvalue. Whenever the market moved away from value, Iwould take the opposite side of the trade. Thus, for the• 22 •
College Years
first time, I would have a reason for making trading decisions —a reference point for trading. And although this ideawasn't fully developed at the time, I want to explain itfurther now because it proved to be so important.
CHARTING THE MINIMUM TREND
The commodity markets at the time were more responsiveand less volatile than now, so this idea started at the righttime and in the right place. (Responsive markets are thosein which people are attracted to buy at lower prices andseil at higher prices. This is in contrast to markets in whichpeople tend to buy higher prices and seil lower prices,which became more prevalent in the 1970s). As you'll see,the method I developed was especially well suited to responsive markets.What I worked out, without understanding it, was a wayof charting trading volume. The underlying formula is simple:Price + Time = VolumeThe three-minute minimum trend chart I developed wasreally a chart of people using, or not using, various priceareas of the market. These minimum trend units, I found,would form a bell curve, looking something like Figure2-1. As you can see, Figure 2-1 is a perfect example of theso-called normal distribution of price/time usage in themarket — a perfect bell curve. This is the form responsivemarkets took, and still take today. If you look at a volumeprofile of any responsive market of today, you'll find asymmetrical pattern of much the same sort. Figure 2-2 isan example.23
College Years
Figure 2-1. A sample minimum trend price/time chart.
As a trader, I was basically playing for this symmetricalpattern to develop, using the number of minimum trendsat each price level äs a timing device. I would play for thehigh-volume price to be at or close to the middle of theprice ränge. Of course, the commodities markets were verydifferent in the 1960s from now. They moved very slowly;the market might take a week or ten days to complete whatwe now consider to be a very small distribution. A tradercould fade or go against a higher or lower opening in anymarket, and this strategy would work about 95 percent ofthe time —again reflecting the responsive nature of themarkets. So my simple strategies worked well —much better than the same strategies would work today.To illustrate my trading technique in the 1960s: Supposewe had a half-completed distribution at the end of a tradingday. The minimum trend profile might look like Figure2-3.Suppose the market opened the next day a half-centlower, at 261. I would be a buyer of the market, knowing
that the market was unbalanced and must come to balancein a responsive Situation. So I would be basically countingthe number of minimum trends at each price and playingthe fill-in, knowing that when the bell curve was completely filled in, I would be out of time at each price. Thus,I was using time rather than price äs the key factor in mytrading.Figure 2-4 shows the second day's activity, following thatof Figure 2-3. The O's represent the minimum trends onDay 2. Just by counting them and looking for the comple-
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MARKET PROFILE (R) COPYRIGHT 1984 CBOT.COPYRIGHT 19B7 COG INC.
Figure 2-2. Volume profile, S&P Index Futures. Note the almost perfectly symmetrical pattem of volume bars, with the high-volume price near the exact center ofthe ränge.
•
Steidlmayer on Markets
tion of the bell curve (in both X's and O's), I could seewhen I was running out of time at a given price.Having developed this method, I had accomplished myfirst objective in trading. I could now understand whereprice was and the conditions surrounding price, in thepresent tense.
College YearsI was thinking about the marketplace at the ChicagoBoard of Trade (CBOT) äs a place to convert my ideas intoopportunities — a forum for marketing my ideas. I knewthat in real estate or any other business I couldn't justknock on doors and make deal s, even if I was willing topay a good price or seil cheap, because no one would beinterested; there would be no liquidity in the marketplacefor my projects. At the CBOT, however, I could marketmy ideas right in the pit. There would always be someoneto take the opposite side of a transaction; and then theright thinking would win.During 1960 I served in the U.S. Army, and, throughoutmy time in the Service and immediately after my discharge, I always had the commodity markets in mind. Ihad previously wanted to do something in agriculture, butopportunities there seemed closed because it was a highcapital, low-margin game. By contrast, I feit I could tradewith a low-capital, high-ability strategy. So the CBOTseemed like the place for me. Although I had the educational background, the ideas and the desire to go forward,
THE MARKETS-SOLVED?
I was very excited about my discovery, and I called anolder friend of mine, a well-respected trader. When I announced that I had "solved the markets," he said that thiswas ridiculous. At first, I was taken aback. But I thoughtabout it and decided that my friend probably had a gooddeal of frustration in his life äs a trader, and for that reasoncould not accept the fact that I had solved the markets. Allthis, however, was based only on theory. So I decided that,äs soon äs I could, I would try to put my ideas into practice.
Figure 2-4. Minimum trend time/price chart for Day 2, showing the completeddistribution in the form of a symmetrical bell curve.
26
27
Steidlmayer on Markets
I still lacked the confidence, the courage and the capitalto get started.So I stumbled around for about six months after gettingout of the service. My father would clip Job ads from thepaper for me and teil me that I shouldn't be "too proud"to work for someone eise. But I just kept on doing what Iwanted to do —trying to put together real estate deals,trying different things. I was still sorting things out andlooking for a direction in my life.
In January 1962, I decided to go to Chicago to see whatwas there. I didn't know where I was going; I didn't knowwhere LaSalle Street was; I didn't know where the Boardof Trade building was; I didn't know anybody in Chicago —but I was going.
FALSE START
I said goodbye to my parents and arrived in Chicago on acold, miserable day in February. There was snow in thestreets, and it was black with coal dust. It wasn't veryappealing to a young man firom California.I went straight to the Board of Trade and proceeded upto the balcony overlooking the trading floor. My hope formarket liquidity disintegrated. Down below were a bunchof empty pits. There were about six people standing in thesoybean pit, and there was no activity —no runners, nophones ringing, nothing going on. I decided to go back toCalifornia.Back in California, I worked on my brother-in-law's farmand helped my father around the ranch. But I spent mostof my time dreaming up real estate deals, trying to putpackages and deals together, knocking on doors and getting28
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Steidlmayer on Markets
Chicago
turned down. I thought my business ideas were sound,but people didn't like them. I was constantly scheming updeals that would allow me to make money without money,but no one was willing to fill in the other side of the equation. Nevertheless, I was confident something was goingto happen.A good Situation was developing in soybeans in the springof 1963. A short crop and a dry planting season broughton a pretty good price move up —about 30 cents a bushel.At this point I was trading the minimum trend, althoughI hadn't developed a charting method yet. Instead, I wasjust visualizing prices and using my mental images äs aguide. I caught most of the up move in soybeans and gotout near the high. When the market went back down, Irepurchased and got out when they went back up again. Ifeit really good about this because it reinforced my idea ofgrouping prices and then trying to buy or seil prices outside of value.This little bit of experience gave me the confidence togo back to Chicago. I told a friend of mine, who was alsomy broker, what I was planning to do, and he decided togo out there with me. This was in the fall of 1963.
day. When I got out, all my profit and all my capital hadvanished.So there I was, starting out in Chicago with no money,no friends and not much to go on. I was staying at the FortDearborn Hotel for $1.50 a night. I would wake up cryingin the morning, thinking about the great opportunity I'dlost because of my mismanagement and impatience.I was able to borrow some money from the Bank ofAmerica in California to buy my membership on the Chicago Board of Trade, and I was approved by the CBOTmembership committee on October 23, 1963.At first, I was self-conscious about trading with openoutcry, so I would just stand on the edge of the pit andkeep track of minimum trends and groupings on trends onpaper. Everybody thought I was a conventional chartist.In fact, when I went to pay my membership fees, thesecretary of the exchange said to me, "I understand youuse those charts. We've had a lot of people come and gowith those things."I turned to him and said, "Well, if you knew so much,you wouldn't be secretary of the exchange. You'd be downthere trading."At first, he was taken aback by my brashness. But herespected my candor, and he eventually became a lifelong
As I left for Chicago, I had all my money in the soybeanmarket despite the fact that my father was advising me to"start fresh." I was long 100,000 beans with 17 cents profit.I was sure they'd go up a dollar, and I'd make $100,000.I wish I had listened to my father. I left for Chicago onThursday, and by Friday soybeans were down the limit;they were supposed to be down another 7 cents on Mon-
friend.My approach to trading remained the same: I had tohave a reason to buy or seil, and I would be right or wrongbased on that reason. If I was consistently wrong, I wouldhave to do the opposite of what the indicator told me. ButI had confidence in my ability to read and understand themarket, even with no experience.One afternoon, I was invited out for lunch by two acquaintances, one a member of the CBOT board of directorsand the other a member of the New York Stock Exchange.
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BREAKING IN
Steidlmayer on Markets
Chicago
When we finished lunch, they asked me what I thoughtabout the market. I told them I was taking very smallpositions because I wanted to "build my factory." In otherwords, I wanted to be able to make a series of small tradesand come out with a profit; after building a base in thisway, I would up my volume.At this point, I was basically testing my decision-makingprocess. I wanted to take the input from the market anduse it to come out with a profit; so I made a lot of trades.I was basically a position trader, in that I usually held mypositions all day or for several days.I attribute my early success to the character of the market at the time. In the early 1960s, the market was bothactive and responsive, which allowed my basic game planto work. I came in with a simple program of buying lowand selling high. I figured that if I bought low and it stayedlow, I'd get out; and if I sold high and it stayed high, I'dget out. The commodity markets weren't very volatile then;soybeans would move maybe a dollar in a really big move.Generally, everything eise moved about 10 or 15 cents abushel all year long. Today, we get moves of that size in15 minutes.Getting back to my story: both of the men I was havinglunch with — experienced traders —had positions oppositeme at the end of that day. I was worried that I might bedoing something wrong because these men were obviouslyvery successful.
SUCCESS IN A RESPONSIVE MARKET
The next morning, I considered getting out of my positions right away, but I decided to give them a little time.Within a couple of hours, the markets went my way. Iknew then that, although I didn't have äs much experienceor direct knowledge äs the other people in the market, Ihad a good sense of how the market was organized, and Iwas on the road to becoming a very successful trader.
I was firmly convinced that I had the best idea out there.I was going to measure the market in terms of time, andI was going to measure market conditions in the presenttense. In an uncertain market, it is hard to predict withbetter than a fifty fifty shot. So rather than predicting, theidea is to try to understand current market conditions. AsGraham and Dodd had shown, the value of a stock is determined by underlying conditions. If conditions change,value changes. But if the market is inherently strong, noblow can break it.I found it very useful to spend my afternoons studyingmy purchase and sale sheet from the previous day to seewhether I had been reacting properly or failing to takeadvantage of the füll potential of my trades. I used this äsan opportunity for critical self-analysis. I might say, "I boughtsoybeans right at the low today, but I took only a quarterof a cent profit. What did I do wrong?" This practice ofself-analysis became a key element in what I called myequation of results:Market Understanding X You = ResultsIn my first year of trading, I found out several key thingsthat played a major role in the development of my theoryof markets. I did this without any research; it came fromexperience and observation. While gaining trading experience, I was also learning how markets work and how toread them.One belief I've always had is that young people adaptto situations very well. Like seeds in a greenhouse, theygrow to fit their environment; but when stress comes —when the temperature changes within the greenhouse orthe roof falls in —they have to make an adjustment. Sevenor eight years usually pass before that happens to a young
• 32 •
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,
Steidlmayer on Markets
trader just coming on the floor. I was lucky to start out ina responsive market with a responsive trading program. Idon't know whether I would have survived in an initiatingstyle trading market.Let's digress for a moment to explain how responsiveand initiating markets differ. Initiating activity is the opposite of responsive activity. In general, in initiating activity, higher prices away from value attract buying, whichproduces further upward market movement; on the otherhand, lower prices attract selling, which produces furtherdownward movement. In responsive activity, the oppositeis true: higher prices attract selling, while lower pricesattract buying. In essence, responsive activity means thatthe market has found a fair price to distribute around,while initiating activity means that the market is seekinga fair price in a new distribution.Figure 3-1 illustrates what initiating activity looks like.The market doesn't remain in Distribution l, äs it wouldin a responsive market; instead, it moves to a new distribution which is unknown until it finds a new, lower fairprice to distribute around.When I first came to Chicago, we had very few initiatingdays, but when they did occur, I always lost money. I couldsee this because my minimum trends showed an imbalance. I would get hurt on such days because I would anticipate when the market was going to change. My basicstyle was not to go with the market, but to go against it.
Chicago
Figure 3-1. Minimum trend time/price chart. Distribution 2 begins when the market moves lower, seeking a fair price, having rejected the price area found in Distribution 1. In this example the second distribution is initiating — seeking a fair price todistribute around thus becoming responsive.
Because I didn't know anybody in the pit, I developed thehabit of observing closely the people around me. I was
always trading well when the pit was füll of people. Thiswas because when the pit was füll, the market was apt tocontinue moving in the same direction. When the pit emptied out, it was a period of low activity, meaning that themarket would change direction. Often, I would still havemy position on, and when the pit filled up again, the market usually would go in the opposite direction.This happened to me enough times during my first twomonths in Chicago that I began to get out of my position
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LEARNING BY OBSERVATION
Steidlmayer on Markets
Chicago
whenever I saw the market stop and the pit empty out.Then when the pit filled up again, I would go with thenew market direction.Later, when I formalized my understanding of the markets, I realized that this was related to the phenomenonof trade facilitation. When the market stops trading activity, it's near the end of the distribution on a day basis. Ididn't associate this beyond a day for quite some time, butit's very relevant to reading the market, äs you'll see later.During this period, I gradually learned not to acceptthings äs they were presented. One of the great fallaciespropagated on the floor was that the commercials and thelocals could cause the market to move. It took me aboutthree months to realize that even when the locals and thecommercials bought very heavily, they couldn't move themarket very much because they were just making tradesfor the day—they weren't holding on. And these tradeswould be offset by other commercials and by traders' resting Orders.So I wouldn't watch the locals and commercials for cluesto price direction. The real directional strength in the market came from the people buying the off options — thosefor the more distant months—which represented about 10to 15 percent of the market's volume. When these peoplestarted buying, they bought and didn't seil, so they wouldtighten up the pit by absorbing the available supply. Themarket would be moved up and down by a few days ofpeople buying off options, not by those trading options ofthe nearby months.So I had separated the market into two parts: the daytraders, who were trading in the nearby months, and theinvestment traders, who, because of the six-month capitalgains tax laws, invested six months or more out. I observedseveral months later that the local spreaders would be
moving back and forth between the off options and nearbyoptions to even up the order flow from one area to theother. If the order flow from one area was all buy, thespreaders had to come over and cover the shortage, because they would not be able to get any seil Orders in thatOption. With this observation I realized that the marketwas controlled not by the commercials, but by the smallpercentage of traders who held their positions for a longtime. This was an important insight into the directionalmoves of the market.Watching the spreaders operate in the market also toldme that the people who were buying the distant optionsnever bought or sold at the same time; so spreaders wouldhave to carry inventories. In other words, they had to waituntil the market moved high enough to shut off the buyingand bring in selling in order to take off the spread. If theywere scalp spreaders, they would try to take off all thatthey could. They also had to inventory, usually with losses,because there would only be either buying or selling dueto the nature of the perceived opportunity for long-terminvestors at this price.At about the same time, I realized that a premium pricelevel on the nearby contracts compared to the deferredwas always a bearish Situation in grain markets. This wasbecause the market assessed it äs a short-term shortagewhich would be corrected eventually. When the distantmonths were at a premium compared to the nearby, itindicated a long-term shortage. Consequently, this wouldattract investment buying, creating a carrying charge Situation.This understanding was opposite to the perceived wisdom. We'd always get carrying charge markets when themarket was good, which means that the speculator wascarrying the inventory. And this was an indication to me
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Steidlmayer on Markets
Chicago
that the price of the most distant month — twelve monthsout —would set the overall price level for the commodity.If soybeans were trading for $2.50 and the new crop Situation looked good, there was a chance that beans mightgo to $3.00. But if beans were $2.75 or $2.80 and it lookedlike a new crop was going to be priced at $2.25, there wasno way that beans were going to enjoy a sustained rally.
With these realizations, I started to chart the minimumtrends of both the nearby options and the most distantoptions. If the most distant options were very strong, Iwould be buying into the weakness of the front month. Idid very well on this strategy because I knew that no matter how many big locals were selling, they couldn't breakit out the other side. The locals would get in during theday, and the commercial activity would be balanced between the buyers and the sellers. The commercials wouldn'ttake a big speculative position; they were just hedgingtheir near-term commitments and looking for a fair priceduring the day. I was able to determine a fair price by thegroupings of minimum trends. When I got a price that wastrying to make a new low when deferred options were toostrong to make new lows, I really was buying price belowvalue.The biggest compliment I got for my trading ability camefrom two distinguished old gentlemen who traded the offOption beans, when there wasn't much physical activity inthe pit (so they wouldn't get pushed or shoved around).At first, these two men told me they would take the op-
posite side any time I wanted to trade. If I wanted to buy10 or 25 beans, they'd seil to me at the seller's price; they'dmake any trade I wanted. But after about four months oftrading with me, these two gentlemen closed the account.They said I was too good to trade against.There were a lot of successful traders on the floor whohad name recognition and followings of their own. Whenever one of them traded, a lot of other people would comein behind him and do the same thing. The good traderstook advantage of this. They knew that there was going tobe a lot of buying or selling behind them. The good traderwould assess that buying or selling activity to see whetherit pushed the market further. If it didn't, he'd be the firstto get out.This "free peek" at the market was very important anda good advantage for the prominent traders. I realized thatone key to trading success was exposure in the marketplace; and, for the first time, I saw that market activitycould be described by volume. The important thing to notewas the amount of distribution this caused.I also noticed that on the days when the market changed,I usually lost money. When the market moved in one direction with a lot of volume, äs a local trader, I'd seilagainst it and get hurt. Those one and two days a month,I was playing for the same norm that occurred on the other18 trading days, and it was very difficult for me to makemoney. Since each bad day subtracted from my winningdays, I figured that if I could recognize this type of dayand refrain from trading, I'd be money ahead. But whatwas most frustrating was that these losing days were thereally active days in the market.In trying to classify trading days, I first discovered thatwe had two types of days — those that were active early andtraded out during the day, and very big days that devel-
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EXPOSURE, EXCESSES AND THE LONG- AND SHORTTERM TRADER
Steidlmayer on Markets
Chicago
oped all day long and just went in one direction. The offoption traders were the key to determining which type ofday it would be. If they were very active early, there wouldbe a big price ränge that we would tend to stay within. Ifwe had no apparent big activity early but small, continuedactivity during the day, then the market would continuein the same direction without much setback.Another observation I made —perhaps the most important— had to do with the speed of price change. The fasterthe market moved, the more it indicated that the currentprice was an excess or a non-competitive area of the market. As a local trader, you learned to perceive this in varying degrees. The principle behind it was that this excessiveprice area —too high or too low —would act äs a barrieragainst further price movement in that direction. This isone of the best reference points a trader can have.Fortunately or unfortunately, these excesses occur invarying sample sizes. But they are always there, and theycan occur at any time during a trading Session. It's extremely important to pick them up to avoid a no-win Situation — namely, having a position on with no chance thatthe market will go your way.
Price is the lever that regulates these two areas of themarket. In the day area, the purpose of the market is tofind a fair price so that trade can take place. (No one willintentionally trade at an unfair price.) In the beyond-theday area, price regulates the activity of the long-term buyeror seller by moving up and down.For example, if there is a lot of building activity in alocal real estate market, prices for labor and materials,interest rates and other expenses will tend to hold or increase. If in the following year the building activity is cutin half, prices will probably fall. The combination of shortterm and long-term activity creates an opportunity for thosewho discern it. For instance, you can have an unfair lowprice in the day time frame coinciding with a high degreeof buying activity; or you can have an unfair high pricecoinciding with low or neutral long-term market activity.Observations like these give us a set of circumstances thatwe can deal with logically äs traders.From following my experiences and observations duringmy early years in Chicago, you are probably beginning tosee — äs I did — that it is possible to read the market in thepresent tense, not just after the fact. If you can do this,there are definite advantages for you äs a trader.
THE COMMON LAWS OF THE MARKETPLACE
Through my early trading experiences and observations, Ibegan to see that all markets were basically the same. Thecommodity markets were no different from my father selling grain for a fair price or our ranch hands buying usedcars or guns when the prices were attractive. In all marketsthere are two distinct areas and two distinct types of participants — the day trader and the beyond-the-day trader.•40«
41
After about five years of trading at the Chicago Board ofTrade, I began to see the need for some changes in mytrading methods. What do you when the indicators youare accustomed to leaning on no longer work? Experienceis the best form of knowledge; but occasionally you cometo a point at which you have to chuck experience and gainnew insights. This is especially true in a dynamic, changingmarketplace. In such a market, change equals opportunity.A small example illustrates this point. One day, early inmy trading years, I was an active corn buyer at the opening. A very nice old gentleman with about 30 years' tradingexperience tapped me on the shoulder and said, "Son, doyou see those rail car loadings in Chicago? That means thecommercial people are going to be sellers. I advise you toget out of the market."I thanked the old gentleman for his opinion —he wastrying to help a young trader out —but I disregarded hisadvice. I knew that the rail car theory was outdated andno longer reflected the market.
THE ADVENT OF COMMODITY TRADING FUNDS
The first major change I had to adjust to occurred in thelate sixties. For the first time, we had trading by com43
~mSteidlmayer on Markets
Changing Markets
modity mutual funds that would buy huge quantities athigher than high prices. Prices would go up, and insteadof selling, the funds would buy. This was the beginning ofthe historic change in the ratio of responsive to initiatingactivity.For the first time, I realized that enough money coulddrive the market far enough against me in a low-marginSituation so that I'd have to cover it. This was hard for meto deal with because I had always feit that no one couldhurt me unless I was wrong. That was no longer the case.Now my principal was much more at risk than ever before.During the 1968-69 period, more and more commoditytrading funds came into being. The floor trader's strategywas to let them push the price way out of line and thentry to guess when they would end their activity. The ideawas not to make the first trade, but to try to make the lasttrade. However, the volume of trading generated by thefunds created a problem for the floor traders, in that therewas usually a large distribution with accompanying volume. This meant that the market would continue, takingaway any advantage from making the last trade äs well.There was one exception to this — when the funds drovethe price high enough to give us an excess, that is, a quickfall away from the peak price. These excesses in price coincided with a new-found volatility in the market. My confidence level declined at this time because I really didn'tknow how to handle this activity. I was smart enough notto take any chances by selling into ridiculous prices because things were changing, so I had to reassess my position and my approach to the market.My earlier approach had worked for some time, but itno longer seemed viable because the potential profits weresmall in relation to the moves that were taking place. Irealized this, and my volume of trading declined —not be-
cause of losses, but because I cut back my trading so äs tofigure out a new approach. I needed to fix the broken gaterather than ignore it.I've always set a great deal of störe by being in controlof myself and, whenever possible, of the market. The importance of this had been brought home to me once backwhen I was first starting in Chicago. I was long 25 soybeans, and the market was up 6 cents. This meant $1,500profit for the day — a tremendous amount of money for meat the time — but I knew the position was worth a lot morethan that. So I decided to ride it out, even though themarket might set me back.At first, it did set back, to the point where my $1,500profit had declined to $800 profit. But it moved sharplymy way several days later, and I ended up making a largerprofit on the trade. I won because I was in control of themarket and my emotions at all times; my decisions hadbeen based not on money, but on opportunity.Now, several years later, the market had changed. Itseemed that I could no longer control the Situation, äs Ihad with the 25 beans back in 1965. So I was trying to buyrallies and seil breaks a little more often. This was extremely difficult to do because I had been conditionedagainst it. I could understand the need for the market tochange in order to attract new participants and grow, butI wasn't adapting to the change; I was avoiding the Situation. It took me about six months to regain control. OnceI did, I could buy rallies or seil breaks without being nervous. I was back in step with the markets.This reinforces the meaning of my basic equation:
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Market Understanding x You = Results
The seventies proved to be an exciting decade for commodities due to the tremendous upheavals in most sectors
Steidlmayer on Marketsof our economy. But it would have been a traumatic periodfor me had I not been able to make the earlier adjustment.Many people who were successful during the seventies losttheir money in the eighties because the markets changedagain, but they didn't. So one of the keys to being a successful trader over a period of time is to adapt to change.You must be able to find a new program when one isneeded and have the discipline to implement it.
THE 1970s: GREATER MAR