1. "Forget what you believe and believe what you see".
2. "The market will do all it can to make you wrong".
3. "Until the market is ready to reflect your interpretation
of the fundamentals, stand aside".
4. "If you torture the data enough, it is sure to confess".
5. "When 95% of traders panic, the other 5% get richer".
6. "Treat the market as your friend. Don't take from
the market...just accept what it offers; losses as well
7. "Markets must be permitted to breathe so don't stare
at the screen".
Paraphrasing the U. S. Post Office motto: "Neither Rain nor Snow nor Gloom of night (nor Central Banks, G7, PPI, CPI, Unemployment Reports, Funds nor various Cartels or The Treasure Secty.) can change a trend!"
What is Technical Analysis?
First let's look at the 3 types of analysis:
1. Fundamental analysis
2. Technical analysis
3. The seat-of-the-pants analysis
Number 3 needs no explanation. It really means no analysis at all - just impulsive trading. That kind of analysis will eventually cost the trader his capital.
That leaves FUNDAMENTAL and TECHNICAL analysis. Which one is better? As a technical analyst myself, I cannot objectively answer that question. However, at the risk of sounding like a politician, I might suggest that a bit of each is good. That applies only if the analyst does not permit one analysis to influence his thinking on the other. I will attempt to describe both in general terms.
Day to day prices changes are traced out on a chart. This price action is the net result of many complex (and unknown) factors. For the sake of simplicity, we'll broadly classify them into three spheres of influence:
1. Socio-economic: Business conditions,
Legislative action and Political developments (including
2. Natural Phenomena: Weather changes and acts of
God (floods, earthquakes, droughts etc).
We will discuss the third one shortly.
The funadmental analyst must weigh the factors in all spheres, balancing the bullish and the bearish in order to make a price projection. Therefore he must have a thorough knowledge of the markets. This is not an easy chore for an analyst following more than a handful of markets.
Newspapers and trade journals usually offer their fundamental interpretations. But it is not their interpretation that interests the Technical Analyst!
Beside the Socio-Economic and the Natural spheres we have a third sphere called the Psychological..
The psychological sphere reflects the aggregate interpretation of a market by all traders. It is this interpretation that should interest the trader... because this is the price mover.
The psychological reflects how other traders feel, how they interpret the socio-economic and natural developments in terms of what they want to do. It is they who ultimately move prices.
Price movement takes place against a background of reports covering weather, crops, economics, politics, war scares and other news. Some of these reports, however, are not in themselves reality but only interpretations of the total situation and they're usually incomplete and late. Besides, it's not the facts and figures that affect the price directly, but rather the reactions of the traders who buy or sell in response to the news. Many times the same development is viewed as bullish by some and bearish by others. As a matter of fact, a market very often doesn't move in response to certain news just because it's already been discounted - the previous price action has already accounted for such a development.
If prices don't move in the direction the fundamental analyst thinks they should, based on his interpretation of a development - he cannot be insistent - the market is stronger than he is. If he insists, it would be like attempting to cross the street with the traffic light in his favor. There is a car coming towards him and he knows that the car SHOULD stop... but he ALSO knows that the light is in his favor. So he proceeds to cross the street... he will be dead right!
One drawback to fundamental analysis, besides its complexity, is that although the trader may ultimately be right, he usually enters the market too early or too late... his timing is bad. Chart analysis can provide better timing which should result in a better price. Chart analysis signals you (and this is very important) IF and WHEN the market is ready to reflect fundamental developments. Until the market indicates that it's ready to do that the trader must exercise patience.
"There's a time to be born and a time to die, A time to laugh and a time to cry". In trading, there's a time to buy, a time to sell, AND a time to do NOTHING."
Looking at a commodity chart one can see repetitions of up and down movements. This represents an argument between the bulls and the bears. If the bears are stronger than the bulls... prices go down. If the bulls are stronger than the bears... prices go up. If there's no net change in price during this argument that means that the odds are 50/50 on the outcome. It means that the bear is as strong as the bull so prices move sideways. If on the other hand one sees price patterns that indicate that the bull is stronger and will ultimately win the argument, you bet on the bull. The same applies to the bear. That is the type of message that a market sends forth.
Two analysts may not interpret the same chart the same way. It's like a biblical passage - it's open to interpretation. Technical analysis is not an exact science - it's an art.
We can conclude therefore that fundamental events move prices, but it's more accurate to say that prices are actually moved by traders. It's even more accurate to state that price movements are caused by the traders interpretation of fundamentals.
When we look at a chart and we see wild price swings, we are not looking at wildly changing fundamentals. We're looking at behavior, at wildly changing emotions - at wildly changing traders interpretations of fundamentals or their anticipation of fundamental changes.
It's not unheard of, for prices to suddenly reverse, while the fundamentals remain unchanged. This is simply a change in the traders interpretation of those fundamentals.
Futures are highly leveraged and this leverage could work against as well as for the trader. What some people may NOT realize is that this same leverage will, at times, cause prices to swing above and below fundamental values.
Fundamental analysis is an analysis unto itself. It does NOT take into account the psychological... the price mover himself... the trader and his behavior.
I could define Technical Analysis simply as "The study of price movement". By that definition it reflects all three spheres that we described: the 1st, the 2nd and, most importantly the 3rd- the psychological.
We should agree by now that traders move prices. What makes that so unique is that traders are human. Being human, we all have one trait in common. We are repetitive by nature. If we're willing to accept the fact traders are human and therefore repetitive then we should be able to predict their behavior - with at least some degree of accuracy.
How can we predict their next move?. TECHNICAL ANALYSIS. Such analysis can be as simple or as complex as one wants to make it. It's based primarily on the repetitiveness of traders and their patterns which become apparent on a chart.
Pattern recognition is based on the premise that if a specific price pattern begins to unfold, the outcome should be similar to the outcome of that same pattern which may have appeared earlier... a month ago, a year ago or even 50 years ago. Human nature doesn't change. Commodity prices may be different than they were 50 years ago, but human nature is the same and therefore traders behavior, which is reflected in chart patterns, remains essentially the same.
Although the next few paragraphs apply more to a speculative trader, the hedger might find them informative.
There are things to DO and things NOT to do while in the market. One thing the trader must do, which is stressed in every trading bible (which may be the reason why traders avoid it like a biblical plague):
Always have a stop order in force - for 2 reasons:
To protect against a disastrous loss and to protect a profit.
Rules for a stop order.
1. Enter it!
2. Never pick an arbitrary stop price.
3. Never move it away from current prices. Always move it closer.
#1 Enter it.
A mental stop is a point at which a trader proposes to exit the market if his position goes against him by a certain amount. The order is not entered but "will be entered" at the proper time. The common result is that this mental stop is then "mentally" moved further and further away from the market as the position deteriorates... (violation of rule #3). The position is eventually liquidated when the loss becomes unmanageable.
One never knows when some momentous development can suddenly send prices soaring or tumbling against him. Enter the protective stop. Mental stop orders are not actually entered so they are not actually executed.
#2 Never pick an arbitrary stop price.
Pick a logical chart point on a chart. In the case of the Wave Theory stops may be placed just below the maximum retracement expected if long or just above the maximum extent expected if short.
#3 Never move it away from current prices.
A trader is MOST objective before he takes a position - when he originally chose a risk point. Once a position is taken, he is no longer objective. He should not second guess himself. Only if he can define a new logical risk point closer to current levels should he move the stop closer.
Once he has initiated a position, whether long or short, and he sees a substantial profit in that position, his first concern should NOT where to take his profit; he really does not KNOW how far prices will carry - only the market knows that. His first concern should be: Not to take a loss once he has a good profit. The least he should settle for is a wash - a break even trade. So he should be looking for the first opportunity to raise his stop to as close to or better than his entry point - to protect his capital! He should not move the stop unless he is convinced that the new level is a logical one. If in doubt, he should not move it.
I suggest exiting a market, whether with a profit or a loss, with a stop. Only the market knows how far it will go. Leave the decision to exit market TO the market and you do that with a properly placed stop order. Using a properly placed stop order to liquidate a position will result in profits double or even triple those that a trader normally takes. Just as important, it will result in losses a fraction of those he normally takes. One can imagine a change in the bottom line when these two possibilities are added together.
Following the simple rules just outlined will also remove one of the biggest obstacles to successful trading - EMOTION
If a trader's position is against him by less than his risk, it's still a GOOD position. If it is against him by more than his expected risk (because he second guessed himself and did not enter a protective stop or moved it away because prices got close to it) then it is a bad position and should be liquidated.
He cannot think objectively about soybeans if he has a bad position in heating oil. The reason is that part of his energy is being diverted to the bad position. That energy is wasted. He should salvage what he can and get rid of it immediately. He usually finds that difficult to do because his ego refuses to be deflated. Dumping that bad position will then allow him to devote all of his energy to another trade - not to mention the fact that he has money tied up that cannot be used should an opportunity arise in another market.
Hope will not satisfy a margin call nor will it replenish lost capital. This writer has seen situations where a trader had a profitable position in one commodity and a losing position in another. He liquidated the profitable position to finance the losing position. He was wrong and not only was he not willing to admit it, but he compounded his error. He didn't want to "realize" a loss and threw good money after bad.
Since futures trading is a zero sum game, there is no such thing as an "unrealized loss". That is just a bookkeeping expression. If a positions is against him by $20,000 - he lost $20,000! Whether he liquidated that position or not, that loss exists and that money is no longer in his account. It's in someone elses account. He lost it!
I want to point out some quirks about the average trader:
The nature of futures trading is such that the number of losing trades will outnumber the profitable trades. There is nothing wrong with that so long as the trader controls his losses and lets his profits ride. He may have 6 or 7 losing trades against 3 or 4 profitable trades and still show a net profit.
A trader is more nervous with a profitable position than he is with a losing position. This is because the average trader is accustomed to losses. It's only when he has a profit that he develops a medical problem...an overactive thyroid - an impulsive feeling to take the profit prematurely...."before the market takes it back". Well placed stops can cure that problem. Yes, it can be heartbreaking to see a profit dwindle to nothing but that is the insurance premium one pays for the big move. If we are willing to pay for automobile insurance, why not a little insurance when trading futures?
Being on the right side of a market that's trending for a month or two can present another problem. Let's assume that a trader has discipline and knows he should not get out of this very profitable position until the market tells him to. A strange phenomena occurs. He actually get bored with the position. A well-known and successful technical analyst (Jesse Livermore) once said "Never liquidate a position out of boredom". His reason may have been as we said earlier, we don't know how far the market can go so let the market tell us when to get out.
One frequently hears around financial circles "You can't go broke taking a profit"? Nothing can be further than the truth! One will go broke taking profits prematurely because they're usually not big enough to offset the losses. If the market offers further profit, why not accept it?
One sedative I might suggest for that overactive thyroid, is to take a profit on maybe a small portion of the position, if only to satisfy its demands. If the market continues to move higher, and he just cannot get himself buy again at a higher price, at least he will still have a piece of the action, and he would still be partly right.
If he is inclined to take a profit only because he is nervous, he should liquidate only the nervous portion of his position.
If he cannot sleep because of size of his position, he should cut it down to a sleeping size. We all think clearer after a good nights sleep.
Profits will be made trading a trend, and that usually means less trading. If a trader finds that less trading is not exciting enough, then he should trade half of his position longer term, (meaning with the trend) and half short term - if only to satisfy that thyroid problem. But trading a trend should prove more profitable and less time consuming.
Unless one is day-trading, do not sit and watch the quote screen constantly. If your broker does not call you with an execution on your stop order, your position is still good.
There's no room for egotism, stubbornness or impulsiveness. A trader should always be in control of his losses. The marketplace has an enormous appetite for capital and it will take it if given the chance.
When one successfully trades a major move he should not get overconfident. Overconfidence is the feeling one gets just before falling flat on his face.
"The most important thing to learn in trading commodity futures markets or any market for that matter, is not how to make money but how to protect one's capital. The first will come after the second is mastered"