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First Principles of Technical Analysis (1/?)

The building blocks of market structure and price action.

[dc]T[/dc]echnical analysis is the art and science of predicting the future direction, timing, and/or magnitude of a market’s movements, mainly by using information contained in the price changes of that market. The term technical analysis is used to differentiate this approach from fundamental analysis, which focuses on analysis of items such as financial statements, competitive advantage, a company’s management, supply and demand factors, and an understanding of the overall economic environment. There are die-hard adherents of each school who claim that their approach is the only one that makes sense, and that the other school is completely worthless. In reality, most traders use a combination of the two, and the goal of both of these approaches is the same—to try to understand the forces of supply and demand at work in the market.

For very short-term traders, fundamentals usually do not matter because the day-to-day price path of stocks does not depend on elements of their balance sheet, superiority of management, or even the company’s competitive position within its industry. Longer term investors will tell you that the short-term fluctuations of stocks are illogical and are completely random noise, but we know from careful observation of prices that buyers and sellers leave many clues to their intentions. There are verifiable statistical edges to certain kinds of technical analysis, but they must be applied in a precise and disciplined fashion, because the edges are very small indeed.

It is very easy to find books (Amazon lists over 17,500), websites, seminars, and classes on technical analysis. You probably hear traders talking about great trades they have made when the moving averages are set up a certain way and the stochastic fast line crosses some other line… this is what most people think of when they think of technical analysis. Be very careful. There is a huge difference between finding trading “setups” that look good on historical charts and actually placing these trades in real-time. As traders, we do not have the luxury of going back through charts to find the best examples—we must live and work at the “hard right edge” of the chart where the future, the very next tick, is unknowable.

Unless you have made substantial, consistent money with a technical tool (consistent being the key word), it is always good to be open to the possibility that your tools do not work. 99.99% of what you read or have been told about technical analysis is worthless. There is no statistically verifiable edge in moving average patterns and only slight edges in some of the common oscillators. There is no statistical edge to the common candlestick patterns. There are no magic chart patterns that can make sense of the randomness. This is the bad news is—that almost everything everyone thinks works in the market, simply does not work. However, the good news is that it is possible to find an edge in the market that can lead to a consistent trading advantage. The key to this is to understand how the patterns of the market’s movement reveal the true buying and selling pressure behind the market, and this can sometimes give clues to future market direction. That is the true foundation of technical analysis, and this is the principle upon which my upcoming book is based. It is not possible to reduce trading decisions to a simple set of rules or patterns to be applied blindly.

Rather than focusing on specific trading patterns or setups in these blog posts, I want to lay out some basic principles that drive price action in all markets and all timeframes. These are not foolproof rules, but they do apply universally to stocks, futures, forex, cash commodities, bonds, or, indeed, to any liquid market. We see these same principles driving price action on one minute bars or monthly bars. In addition, these appear to be fairly universal and unchanging. We see the same principles at work in grain prices from the Middle Ages, or in stocks from the 1700’s that we see in today’s markets. Traders will of course need to adapt to new markets and new timeframes, but our goal here is to lay out a more or less universal framework that can provide a basis for trades in any market. These principles are:

  • Markets alternate between trends and trading ranges.
  • Trends are more likely to continue than to end.
  • Trends, when they do end, usually end in one of two specific ways.
  • Last, I will lay out some characteristic price patterns around support and resistance holding or failing.

More to come…

AdamHGrimes

Adam Grimes has over two decades of experience in the industry as a trader, analyst and system developer. The author of a best-selling trading book, he has traded for his own account, for a top prop firm, and spent several years at the New York Mercantile Exchange. He focuses on the intersection of quantitative analysis and discretionary trading, and has a talent for teaching and helping traders find their own way in the market.
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