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John Netto explains how he trades market sentiment and the tools he uses to do so.

My guest today is John Netto and he looks at something called market structure in influencing his trading decisions.  John, first of all, what is market structure?

Sure.  Market structure is, along with using fundamental analysis and technical analysis, understanding how the market’s positioned goes a long way in determining ultimately how the market will react to certain events.  One thing that people talk about is looking at the Commitment of Traders reports put out by the CFTC every Friday showing the previous on Tuesday. You can take that same theory of understanding, okay, is the market long specs, long commercials, short specs, short commercials, and how that plays a factor, but also the overall sentiment behind the move.

I’m not the type of guy that likes to wait three days for Tuesday’s data on Friday but I also like to develop a feel and canvas my colleagues and canvas people in the industry to get a sense of how people are positioned because if we have a Non-Farm Payrolls number that comes out on a Friday, okay, and the market is generally leaning for the number to be stronger and the market has rallied into that, you can get a much better bang for the buck or asymmetrical risk:reward ratio, meaning you get a much higher reward than you will risk you’re taking if you can position yourself short or to fade that number.  Conversely if you’re looking to be long in number where the market’s already priced itself in, you may have to adjust your size as a result of the price action that’s preceded that or how the market has structured itself around that trade. 

Alright, so if sentiment is bearish or bullish, whatever it may be, do you use it as a contra-indicator or does it vary each time? 

Well, I think you need to understand the catalyst to go behind it so not only is structure important, but if you can get a sense of one, what are the drivers that are pushing this market so if we take an issue like the fiscal cliff, alright, or an issue like the election okay.  Those are drivers of global macro catalyst that people are making decisions over tens of billions of dollars of allocations and they’re reconfiguring all of their entire asset allocation models on, so positioning there is a little different than positioning just in the middle of the year when there’s not a driver than can move the market one way or another.

This sounds a little bit like following smart money.  You hear this term like we want to follow the institutions, follow the mutual funds, because they tend to get it right more often than not.  Is this part of it?

It’s an aspect of it, but keep in mind, that it also goes along the time frame as well so if I want to understand how the market could possibly react on a Monday, Tuesday, or a Wednesday, versus how can it react over the next two, three, four, five weeks or even the next two, three, four, five months, the smart money to me has positioned themselves for months at a time whereas a number of the hedge funds and retail investors can influence the market from a day to day perspective.  Now if we get a big catalyst like we got with let’s say the election, okay, that’s where it all comes together.  That’s when you get this crescendo event that can offer both short-term traders and long-term investors tremendous opportunity to participate in price discovery and that’s understanding how the market’s structured or how it needs to get structured as a result of events that have just taken place. 

Alright, and finally maybe an example, is it, sounds like it could be if Apple has great earnings but it’s priced already into the market and the stock goes down, you think great earnings means a higher stock price but market structure might explain why it would go opposite.

And I’ll even add to that Apple example.  Market structure might explain why did Apple, a widely held stock, would sell down so rapidly like its highest is north of $700 down to the low of $507, okay, why would a stock that was so widely held slow down so much?  Well, we have the issue of capital gains, we have the issue of a number, it’s widely held by institutions, it’s widely held by retail investors, and you have this big collective exit trying to get out at one point in time so it’s a case of collective structure from top-end institutional clients, hedge funds, growth funds out there, and retail investors all needing to get out because of various reasons that all come together.  That’s an aspect of market structure and catalyst can provide you as a short-term trader a real nice opportunity to go short that stock as a result of all those metrics.