[dc]I[/dc] want to share a few thoughts today on technical trading in general. The points in bold come from the end of the first part of my recent book, The Art & Science of Technical Analysis. I expanded each of those with a little more commentary. These points and ideas apply to all pattern-based or technical trading systems. Take a moment, step back, and look at your own trading from this perspective. Many times technical traders struggle because they are either using patterns that don’t actually have an edge, or they do not understand the importance of waiting for a clear entry. Making some small adjustments to your trading plan can have a big impact on your bottom line.
Markets are highly random and are very, very close to being efficient.
If you are a new trader, trading is probably harder than you think it can be. If you’ve been trading a while, you know this. Financial markets are one of the most competitive environments in the modern world. New information is quickly processed and incorporated into prices. This means that you cannot outsmart the market consistently. You cannot invest based on what you think makes sense or should happen because you are up against investors with superior access to information, knowledge, experience, capital and other resources. Most of the time, markets move in a more or less random fashion; you can’t make money if market movements are random. (“Efficient”, in this context, is an academic term that basically means that all available information is reflected in prices.)
It is impossible to make money trading without an edge.
There are many ways to create an edge in the markets, but one this is true—it is very, very hard to do so. Most things that people say work in the market do not actually work. Treat claims of success and performance with healthy skepticism. I can tell you, based on my experience of nearly twenty years as a trader, most people who say they are making substantial profits are not. This is a very hard business.
Every edge we have is driven by an imbalance of buying and selling pressure.
The world divides into two large groups of traders and investors: fundamental traders who base decisions off of financial analysis, understanding of the industry and a company’s competitive position, growth rates, assessment of management, etc. Technical traders base decisions off of patterns in prices, volume or related data. From a technical perspective, every edge we have is generated by a disagreement between buyers and sellers. When they are in balance (equilibrium), market movements are random.
The job of traders is to identify those points of imbalance and to restrict their activities in the markets to those times.
Since we cannot profit consistently (i.e., above the probability of a coin flip) in random markets, it makes sense that we should limit our exposure to times where there is a clearly-defined imbalance of buying and selling pressure. When this occurs, which is often visible in certain patterns in prices, we now have the possibility of creating trading profits. This, identifying the imbalance, is the first step in any technical trading.
So, ask yourself some hard questions: Do you understand how to identify points of imbalance in the market, and do your trading patterns respect this reality? Do you believe that markets are usually random? Do you understand that no profits are possible in random markets—that nothing will help? Not money management, exit strategies, or positions sizing. You must wait for an imbalance to emerge on your timeframe, and, only then, take action in the market.