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.


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