Thursday, October 04, 2007

Surface vs. Deep Reasoning in Technical Analysis

In a recent post, I outlined some of the basics I emphasize to new traders, beginning with a fundamental understanding of value, trading ranges, and why markets break out of ranges and trend.

Technical analysis appeals to many developing traders. Regrettably, much of what passes for technical analysis might be called surface analysis. Examples of such surface reasoning would be:

* We’re seeing an XYZ chart pattern; therefore I’m bullish;

* We’re overbought on the ABC indicator, so I’m selling the market;

* The market is trending higher, so I’ll buy it here;

* We’re making a new low, so I’ll sell it here.

To be sure, surface analyses are not unique to technical analysis. Surface fundamental analysis, for example, seems to be a specialty of market permabears, but comes in several flavors:

* The recent economic reports have been weak, so the market is going down;

* The dollar is weak, so we’re headed for a crash;

* The market is making new highs, so we’re in a bubble and headed for a crash;

* The economy is strong, so we will continue a bull market.

What makes any reasoning surface is the reliance upon simple cause-effect relationships. When I work with traders at investment banks and hedge funds and see the millions upon millions of dollars they spend on research and analysis, I have to shake my head at traders who would rely upon simplistic, linear thinking. If those cause-effect relationships were significant, those ultra-competitive firms would be only to happy to exploit them.

(A topic for another day is the reverse: How professional firms create hazards through excessive complexity. I’ll be taking a look at a recent book on this topic in a future post).

Technical analysis, however, need not be surface. Price-volume relationships, examined over multiple time frames, can yield valuable insights into valuation and the market’s auction process. Similarly, careful looks at how individual stocks and sectors are behaving can provide clues as to emerging market strength and weakness that either confirm or disconfirm the movements of the popular, capitalization-weighted indexes. When we examine correlated markets, we can obtain insights into capital flows that are most relevant for whether equity traders are assuming or avoiding risk.

The chess grandmaster doesn’t think in linear terms, move by move. Rather, the grandmaster sees configurations of pieces and understands their strategic significance. That helps the expert to think many moves in advance. The market is like a chessboard in that respect. Configurations of relationships, not simple if-then/cause-effect sequences, enable the successful trader to understand market movements and participate in them. We know a trader is developing when his or her market perspectives deepen, becoming richer with experience.


Ten Lessons I've Learned From Traders

Defining Qualities of Market Pros


Trader Musings said...

Looking forward to your discussion on how professional firms create excessive complexity.

I'm beginning to believe that successively trading the markets has more to do with understanding trader perception's of market information rather than the market information itself.

Also, released market information is actually past history. The markets, I believe, trade most of the time on anticipation of new information yet to be released, rather than information already known. In other words, the markets are more forward looking than backward looking.

In summary, try to understand how the markets are anticipating new, yet to be released information, rather than trying to understand how the market should react to known information.


F-Trader said...

This is also what good corporate leaders do. They keep tabs on the most recent developments in their industries. They are hyper-aware of environmental nuances that can give them an edge. Knowing what's happening at the margin allows them to formulate hypotheses create a vision for the company, reinvent themselves when necessary, and properly allocate resources to the most promising areas.

I would not be surprised if successful portfolio managers function in the same way.

Jeff said...

Thank you for yet another insightful post! although on the face of it this post may seem to state the obvious, it (and your other related posts) is nonetheless clarify and elucidate issues that were blurred, to me at least.

Stacey Renee said...

I look forward to reading more about what you've learned about the reasoning of successful vs. unsuccessful traders. I am not sure if this is a function of my growth or a function of the markets; but in the 3 years I've been trading it has seemed like the various markets have become more and more intertwined. If that perception is true, then I cannot see how someone can be successful with the simple linear thinking. I liken trading to a game of bridge instead of chess. Bridge is just as strategic in many ways, but it's a game of incomplete information, unlike chess. Whichever analogy you use, though, trading is far more difficult and complex than any game we could conceive as the rules are much more open.


GHummer said...

I found your blog about a month and a half ago and have become a regular reader. It's great stuff. I have a quick question about trading: How important is higher-level math when it comes to trading successfully? I have taken courses in econometrics and math up to calculus 2, but every day I read about hedge fund managers with phDs in physics, mathemetics, statistics etc. and cannot help but feel somewhat inadequate that I do not possess that higher-level understanding of numbers.

Brett Steenbarger, Ph.D. said...

Dear Readers,

Thanks for the perceptive comments. Very good point regarding understanding how markets are processing current information; the recent reports of bank losses and how those have been absorbed by the market is an excellent recent example. I also like the analogy to bridge. The interconnection of economies and markets makes it difficult for all but market makers to trade without an eye on the entire playing field.

And, yes, there is an interesting correlation between how portfolio managers manage money and how corporate leaders think. It's the ability to have one eye on the big picture and the other eye on detailed execution.

I don't think higher math is necessary for successful trading, but it does open areas of opportunity. The quant funds, recent losses notwithstanding, have done very well with sophisticated modeling.