We have learned from the book "Order Flow Trading for Fun and Profit" that metagaming is a term used to define any method or strategy used in a game (read: the markets) that goes beyond a prescribed rule set and includes external factors to affect a game. In short, we have first to learn about the possibilities and limitations that exist in the marketplace (market microstructure), recognize who is participating in the markets and what their characteristics are. Finally, we can combine all of this to exploit the various market inefficiencies that exist.
In this article, I will show several examples of how metagaming can be applied when trading. However, it is important that you not limit metagaming to those examples, but make it part of your trading. Whenever you make a decision in your trading, may it be entering/closing or modifying a trade, you must think about what other participants might do and how this can affect your position.
First of all, I want you to understand that while large market participants like dealers and hedge fund prop traders certainly have an advantage given the amount of information and resources they have, they still can get caught on the wrong side of the market and make obvious mistakes. They may not use always physical stop loss orders like almost all retail traders do, but even then, they will have a mental stop – a price point where their trade idea does not make sense anymore and they have to cover their position. The main task for dealers is to trade with various clients in the first place, but they also engage in prop trading where they speculate on short-term price movements. When a dealer anticipates a stop hunt and positions himself for this, price might run into heavy orders ahead of the stops and he will have to cover. Funds can get caught on the wrong side as well, if there is a larger squeeze or fundamentals have changed. We cannot know what i.e. Goldman Sachs traders are doing and what they are thinking, however, the goal of metagaming is not to get such details, but include market psychology and apply it on a large scale. To get to the point: As long as there are humans involved in transactions and we are aware of their characteristics, their behavior can be predictable.
Determining sentiment is not all about fundamentals! Price itself plays a very important role. We are not talking about indicators or any other technical tool, but really price itself. For example, let’s assume EUR/USD has been trading in a 1.32-1.34 range for the past few weeks and sentiment is mixed. There was little significant activity and positioning is rather flat overall. Further, EUR/USD is currently trading around 1.3350, so pretty close to the 1.34 level. There were no changes in fundamental and sentiment amongst most market participants is still mixed. They prefer to trade currencies which clearer bias, like i.e. AUD/USD.
Now, let’s say one day, corporates have large demand for Euros. They don’t care about fundamentals or anything, they just want to get the Euros they need for their business transactions. Given little interest in the boring EUR/USD, the corporate demand will push price higher. Dealers will anticipate this and also buy; perhaps they can even get those stops above 1.34 triggered and earn a nice, quick profit. The informed players will know that this rally was caused by a few larger transactions and that there were no real changes in fundamentals. For them, the 1.34 area will be an opportunity to sell EUR/USD and anticipate a move back to the lower range.
However, for the uninformed player, this will look pretty exciting. He will see getting price near 1.34 quickly and buy in anticipation of a break. Some will wait for the actual break, but once it happens, they will rush into buying the pair. Every trader will know the feeling of seeing volatile price action and having the NEED to do something. This is what distinguishes the true professionals from the amateurs – they can control themselves. To get back to the point, the price move itself influenced sentiment for the uninformed players. They will buy into this momentum thinking something has happened and they need to be part of the move. This will be fueled by the buying of dealers and algo programs that accelerate momentum. But once the stops above are filled and the selling from informed players comes in, price will quickly turn. The traders who bought into the rally see their stops getting triggered and they realize that they got a false feeling for sentiment because of the price action.
If we see a rapid move in price, we want to see how price behaves once things settle down a bit. Assuming there is a sharp rally in i.e. GBP/USD, we want to observe if the dips are still well-bid or if the move is losing steam rapidly. A valid price move will have healthy retracements, but it is the type of retracement that will tell you more about the whole situation. Taking the GBP/USD example again, if there are smaller retracements to the downside after a larger up move, but they still run into decent buying interest, we can assume the pair has potential for further gains. If overall sentiment is confirming this, even better!
Inefficiencies happen every day, many times. Markets are in a constant search for liquidity and therefore other participants look for the weak hand in the markets. The weak hand is the group of participants that is trapped on the wrong side of the market and whose stops are vulnerable. Other traders will usually target their stops or squeeze them out of their position to gain advantages for themselves. This is a completely normal process in the markets and has been going on ever since markets exist! What can give you an additional advantage in your trading is applying the metagame concepts in your trading.
When you are buying/selling, what is the reason you do so and can you reasonably expect other participants to do so as well? If you are buying the EUR/USD only because of better than expected German economic data, but the data was released already an hour ago, it is very likely you will be too late to the party. Where will you place your stop and what favors placing it there? You don’t only want to place your stops beyond orders, but also include the power price has on sentiment.
Imagine you are a day trader, have good reasons to short EUR/USD and there are large offers reported at 1.33. It makes sense placing your stop above there because other participants are looking at that level as well. If markets absorb those big offers rather easily, there will be increased demand and less selling interest, driving the price higher. Even if you have good reasons to be short EUR/USD, you don’t want to fight the flow. It might go 1.3380 and since you are looking for a short-term price move, you certainly don’t want to see your position going more than 100 pips in the red. Wait for both conditions and flows to be in your favor. It is better to be a bit late in your entry but catch a nice profit than to fail several times trying to get a perfect entry.
Your task is now to apply the metagame concepts in your live trading. Don’t focus just on yourself, but apply what you have learned about other market participants to anticipate their actions. Make it a part of your daily trading routine – make it a habit! As price moves and you analyze sentiment, always think about what other participants might perceive and do. You don’t have to over analyze everything, but once you see clear sentiment and identify the weak hand you want to act and exploit them by i.e. targeting their stops.
Metagaming is best learned through experience and hours of watching price action. It might be a daunting task at the first look, but it is definitely worth the effort. Not only will you be able to make better strategic moves, you will identify the weak hand in the market more easily and exploit their decisions.