When I trade the market I use chart analysis to understand crowd behavior. I
also use technical analysis tools to understand price behavior. Why do you
use charting and technical analysis?
Usually the answers fall into two distinct camps. One camp believes
these techniques provide a way to predict market moves and price activity.
The other camp believes the analysis establishes a probability framework.
These divisions are common amongst professionals and amateurs. They divide
traders and techniques.
When you consider applying charting and technical analysis, it is an
advantage to know which camp you belong to. When reading or listening to
analysts who use these techniques, it is very important to know what camp
they belong to. If the analysis is based on a probability framework and you
interpret it as a prediction then you may end up with an unpleasant and
costly results.
*The Risk of Prediction*
We all bring with us to the financial markets a different understanding of
risk and a different solution to the problem of identifying and managing it.
This influences the way we select indicators and understand them. We talk in
general terms about market risk and this hides some important distinctions.
If we believe risk is the same as uncertainty then the obvious antidote to
risk is to reduce uncertainty. In the financial market this typically comes
in two separate packages.
The first package is neatly tied up in fundamental analysis.
Fundamental ratios, analysis and procedures provide a good starting point to
focus our attention on a specific group of stocks. Many people stop there,
believing they have the answer. Instead, they have just a beginning.
Fundamental analysis, in a broad sense, is useful for deciding what to
buy. It is not very useful for deciding when to buy. A common solution to
this problem is to buy quality stocks at bargain prices. We all like quality
and these buyers believe the quality of the stock will overcome market
retreats. They reason that good stocks always perform well, and even if they
do slip a little in price, their quality means they recover quickly. These
investors select quality stocks to lower risk by reducing uncertainty.
The second package contains an analysis system that generally involves
some form of prediction.
The objective is the same for both the investors using fundamentals and
the investors using charts and technical indicators. They aim to reduce risk
by knowing as much about the future as possible, or at least by knowing more
about the future than their competitors. In technical analysis, knowing the
future is often associated with the use of particular indicators or
indicator combinations. The objective is to identify something before it
happens-every time. Technicians spend a lot of time developing subtle
mathematical manipulations they believe help them to tell the future.
I agree with Larry Williams, the US commodity trader who is noted for
turning a $10,000 stake into $1,000,000 in less than 12 months. He notes a
survey of newsletter trading approaches in *Long Term Secrets to Short Term
Trading*. He says the performance figures are very revealing; "I went back
three years and found that the poorest performers in 1995, 1996, and 1997
have consistently been the Gann/Elliott/Acarne group who, as a group, have
averaged a loss of close to 100% a year. This from a crowd that claims all
can be known, that you really can buy bottoms and sell exact tops."
This is harsh criticism, yet some people do use these approaches very
successfully. Closer inspection though often shows they also use good
trading techniques that return good trading results under almost any system.
Personally, I believe risk is not effectively or completely nullified
by techniques designed to tell us something about the future. When I use
tools designed to anticipate market action I apply them within the context
of this belief.
*Probability*
If risk is unable to be nullified by analysis, then where does this leave
us? It doesn't mean we cannot trade the market. It means we re-focus our
attention on what is easily verified and use it construct an understanding
of the balance of probability in any situations. We do not need to know the
future to recognize an opportunity. Aladdin did not know he would find his
cave, but he did know how to exploit the opportunity when he stumbled onto
it.
This is my starting point for trading. I stand in the probability camp.
I accept uncertainty and this determines what I look for when selecting a
chart and indicator combinations for trading the market. I start from the
proposition that I cannot predict the future so I aim to identify the
probability of one outcome in comparison to another. This is the first step
in managing risk.
