Markets Are Not Perfect
Technical analysts often repeat the mantra: “the charts discount everything — all information available to the market is reflected in the current price”.
The market takes time to react to and digest new data. We are not dealing with a vast super-computer that can detect and analyze the implications of every change in market conditions. The market is driven by mass psychology and pulses with the ebb and flow of human emotions. Individuals are seldom comfortable acting alone and are dominated by a vast herd instinct. Markets respond rapidly to extreme events but are more likely to overreact than in times of gradual change.
A Simple Formula
The market is a dynamic system. I often compare trading to a military operation, not because of its oppositional nature, but because of the complexity, the continual uncertainty, conflicting intelligence reports, and the element of chance that can disrupt even the best made plans. Prepare thoroughly, but allow for the unexpected.
The formula is simple. Invest when probabilities are in your favor and apply proper risk management — and you are likely to succeed.
Avoid Making Predictions
Avoid making predictions. The market can go up or down at any time — it is only the probability (of each move) that varies.
Confirmation bias is a forecaster’s biggest enemy. If you make predictions, you are likely to emotionally commit to a position and discount evidence to the contrary. To counteract this, I try to present both bull and bear scenarios wherever practical.
Investment is not an exact science. We never know the outcome of a particular pattern or series of events in the market with 100 per cent certainty. The best that we can hope for is a probability of around 80 per cent. That means something unexpected will occur at least one in five times.
My approach is to assign probabilities to each possible outcome. Actual percentages would imply a degree of precision which, most of the time, is unachievable. Terms used are more general: “this is a strong signal”; “this is likely”; “expect this to follow”; “this is less likely to occur”; “this is unlikely”; and so on. Bear in mind that there are times, especially when the market is in equilibrium, when we may face several scenarios with fairly even probabilities.
Technical analysis acts as a useful confirmation of fundamental views or actions (not the other way round).
Indicators may promise a short-cut to trading success. In my experience, this is a false promise. Technical indicators can provide confusing or contradictory signals and lead to poor decision-making. Never place all your faith in a single indicator. They are imperfect summaries of price and volume action. Nothing more.
Technical indicators highlight certain aspects of a chart at the expense of others. The best source of information is always the chart itself.
Analysis should also be separated into three time-frames: short, intermediate and long-term. While one time frame may be clear, another could be uncertain. Obviously, we have the greatest chance of success when all three time-frames are clear.
Broad market conditions, especially the supply and demand for money, drive market prices. If there is no money to buy stocks, prices will fall. Likewise, if the market is awash with money, prices are likely to rise.
My strategy can be broken down into three key areas:
- Know When to Trade
- Know What to Trade
- Know How to Trade
To be successful, investment strategies need to reflect the state of the economy and stock market as a whole. Adjusting overall exposure to stocks, depending on market conditions, is the single largest determinant of overall performance. No indicator, or system, is perfect but there are a number of proven techniques that can improve your market timing and overall performance.
Technical analysis of stock market indices is an important part of improving your market timing. This includes monitoring of bellwether stocks that serve as lead indicators of economic activity.
Broad Market Indicators
Broad market indicators provide support for index analysis but are not a reliable tool on their own.
This is not an economics course but we will cover some key economic variables that you should monitor in order to gauge market risk.
Volatility indicators like VIX are often too temperamental to serve as reliable indicators but provide useful support for macroeconomic and technical indicators.
Identify stocks that present the best trend-following opportunities.
Proprietary technical indicators, Twiggs Money Flow and Twiggs Momentum are used to scan for trending stocks, as well as ranging stocks with strong accumulation, as potential investments.
Charts are then analyzed in three time frames to confirm investor behavior.
We then apply our Keep It Simple approach to Technical Analysis to gauge trend strength using:
- Trading Range
- Support and Resistance
- Simple Behavior Patterns
This is not an accounting or stock market analyst course, but we introduce some fundamental tools that can help you make better decisions.
Develop patience & discipline, apply proper risk management and follow a systematic process to identify entry and exit points.
How to exercise the patience needed to achieve the right setup. Don’t chase after the market. Let time do its work. And let the market come to you.
Develop the discipline to follow your system and not be distracted by the hundreds of experts all vying to present their view of the market and by the thousands of tips and opportunities presented daily in the media and on the Internet. If you are fishing for marlin, don’t go chasing sardines (or vice versa).
Risk Management is often referred to as Money Management because it involves protecting your capital from excessive risk. Every trade or investment involves risk. There is no avoiding this (other than not trading). In order to survive you need to limit your risk per trade. This involves using stop loss orders and set rules to limit risk.
Both entries and exits are critical to investment performance.
Stop losses and entry points are inextricably linked. Too tight and you are likely to get shaken out of the trend before it really gets under way. Too wide and you risk too much of your capital. Determine entry points using support and resistance and behavior patterns to give you the best chance of staying with the trend.
Gauge trend strength and new support and resistance levels to move your stops up gradually over time, while giving the trend lots of room to move. Avoid some of the biggest pitfalls of trend following and know how to seize opportunities when they present themselves.