The Discipline Behind Translating Market Analysis Into Results, Part I

• December 26, 2002
• Mark Douglas

There are many technical systems and indicators that will generate
consistent profits over time. Unfortunately, most traders are not aware of the
fact that buy and sell signals generated from technical systems or indicators
have some unusual properties and characteristics that can make it extremely
difficult to realize these consistent profits.

As a result, most traders find there is a huge gap between the
possibilities created by a series of buy and sell signals from their chosen
technical indicators and what they experience in their bottom-line performance.
I call this phenomenon the “reality gap” between what is available in
the way of consistent profits and the amount of money we actually end up with at
the end of any given day, week or month.

To make consistent money trading a technical system or any set of
technical indicators, you need to understand exactly what they do, how they do it,
and most importantly, what they don’t do. Not understanding the true underlying
nature of technical analysis will cause you to be susceptible to making any
number of typical trading errors. In other words, either:

1. You won’t be able
   to do exactly what you need to do, when you need to do it, without reservation or
   hesitation or…

2. You’ll be doing things you shouldn’t be doing.

In any case,
you’ll find your trading experiences to be frustrating and filled with stress
and anxiety, as you watch the “reality gap” grow ever wider.

The kind of understanding I am referring to creates a unique
trader’s mind-set that consists of a set of attitudes and beliefs that properly interface
with the underlying characteristics of technical analysis. When your thinking is
in harmony with the basic nature of your methods, it would be an understatement
to simply say “good things will result from your trading.”

However, before you can fully appreciate the characteristics of technical
indicators and the implications these characteristics have on your ability to
take advantage of what they have to offer, you will first have to understand the
underlying nature of price movement.

What Makes
Prices Move?

At the most fundamental level, all price movement can be explained as a
function of what traders believe about the future. Here’s what I mean. If the
last posted price of something was 10, what would cause the price to move up to
11 or down to 9? Someone would have to be willing to buy at 11 by bidding the
price up, or be willing to sell at 9 by offering it lower.

Now, what would compel someone to buy something at 11 or sell at 9 when
the last posted price was 10? If you look at this behavior within the context of
why people trade, it wouldn’t seem to make any sense. People trade to make money
or preserve the value of their assets. I’ve been a trading coach for over 18
years and have yet to encounter a person who put on a trade believing it was a
loser before it he entered into it. There are only two possible outcomes to
every trade: It’s either going to be a winner or a loser. And there are only two
ways a trader can experience a winning trade. He either has to buy low and sell
high or sell high and buy it back at a lower price.

If we assume that everyone trades to win and the only way a trader can
win is to buy low and sell high or sell high and buy low, then why would anyone
knowingly buy at a price that is higher than or sell at a price that is lower
than the last posted price? He would be buying high and selling low, which is the
exact opposite of what he needed to do to make money. The only reason I can think
of is that he must believe the price is going even higher or otherwise he would wait
and buy it at a lower price. And vice versa, he must believe that the price is
going even lower, or otherwise he would wait and sell at a higher price.

Regardless of the myriad of reasons or justifications that traders would
give to account for their behavior, the dynamics of price movement are really
quite simple. In any given market, there are only two forces that act on prices
causing them to move:

1. Traders who (for whatever reason) believe the price is
   low and as a result, expect it to go higher.

2. Traders who (for
   whatever reason) believe the price is high and as a result, expect it to go
   lower.

All price movement is a function of the relative balance or imbalance
between these two forces. If there’s a balance, prices will stagnate because
each side will be absorbing the force of each other’s actions. If there’s an
imbalance, prices will move in the direction of the greatest force. In other
words, prices will move in the direction of the traders who have the strongest
conviction in their belief about what is high or what is low — conviction
demonstrated by their willingness to bid a price up or offer it lower.

Why
Do Technical Indicators Work?

If you distill the force of traders acting on their
beliefs down to the
most fundamental level, what you will have is simply up- tics and down- tics. A
tic is the smallest incremental move in price something can make. A tic would be
analogous to the minimum bid at an auction. So each up- and down- tic represents
what some trader or group of traders believes about what is high or low at that
moment. The accumulation of these up- and down- tics over time can form into price
patterns.

Patterns form because in any given market, there are usually several
traders who share similar beliefs about what is high and what is low. Day after
day, they will do the same things over and over again to make money. All of this
activity creates behavior patterns. More specifically, groups of individuals can
generate “collective” behavior patterns no different than any
particular individual who will behave exactly the same way in certain
circumstances and situations. These collective behavior patterns are observable,
quantifiable (meaning they can be measured) and they repeat themselves with
statistical reliability.

Technical indicators work simply because they define and organize the
patterns into an understandable framework. Once you learn how to recognize and
interpret technical indicators, they will tell you which force, if any, has a
stronger conviction in their belief about the future — as well as where or when
there may be a significant imbalance between the two opposing forces, based on
some pre-existing or developing behavior pattern.

The various patterns generated by the market can consist of visual
formations in price bars like trends, channels, head and shoulders, triangles,
flags, wedges and percentage retracements from previous highs or lows, to name only a
very few. Patterns can also be identified by measuring various relationships in
price data using mathematical equations. Some of the more common mathematical
indicators include moving averages, relative strength, stochastics and MACD, to name only a few that have been developed over the years.

What Do
Technical Indicators Do?

There are literally millions of combinations of ways to massage price
data. However, regardless of the method or combination of methods used, all
technical indicators try to do the exact same thing. And that’s to identify the
presence an “edge.” I am defining an “edge” as an indication
of a higher probability of the market moving in one direction over the other.
Although all edges defined by a technical indicator are not of the same quality,
they are in essence a way to get into and read the collective mind of the
market.

Getting into the collective mind of
the market is a significant advantage for the technical trader, but that’s not
all technical indicators do! If you study the relationship between technical
indicators and price movement, you’ll find that the same price patterns and the
edges they represent will show up in every time frame, from the smallest to the
largest. For example, a daily chart has one vertical line to represent a full
day’s worth of price activity. A five- minute bar chart has 12 vertical lines per
hour to represent the price activity contained within the one line of a daily
chart. A typical price pattern on a daily chart may take weeks to form, whereas
the same pattern on a five- minute chart may only take a few hours to form.

In fact, if I were to give you a mixture of weekly, daily, hourly or five-
minute price charts, but set them up in a way where all you could see were the
black lines representing the price bars without any indication on the x or y
axis of either price or time, you really wouldn’t be able to tell the difference
between them. The charts wouldn’t necessarily look exactly the same, but the
same patterns, both visual and mathematical, would be present throughout the
various time frames.

Now, if technical indicators can be applied to price data in every time
frame with equal validity, then one of the most profound characteristics of
technical analysis is that it turns the market into an unending stream of
opportunities to enrich one’s self. Just think about of the possibilities of
having your very own money machine. If you’re not already “hooked” on
trading, being confronted with a genuinely unending stream of possibilities to
make money can be difficult to resist. It seems like all you have to do is learn
how to recognize if and when an edge is present and then execute a trade. It
seems simple enough and this is in fact true. When done properly, trading is a
relatively simple process.

But don’t confuse something that is simple with something that is easy.
The fact is you will probably find trading to be one of the most difficult endeavors
you will ever attempt to master — at least within the context of producing
consistent results. I am defining consistent results as a steadily raising
equity curve with drawdowns that reflect the normal losses of any trading system
or methodology. Not the equity curve of the typical trader that looks more like
a jagged edge saw where the drawdowns are excessive — usually caused by trading
errors and not necessarily the result of one’s trading system.

What Exactly
Makes Trading So Difficult?

There are many factors that make it difficult to realize
the possibilities created by a
constant flow of edges identified by a technical indicator. At the
most fundamental level, the problem has to do with the way we think. In other words, there are some inherent
characteristics in the way our minds are
wired that don’t interface very well with the characteristics of technical
indicators, or market movement for that matter.

People find too much
meaning in indicators and then transfer their
hopes to them. I will explain what I mean when I discuss the specific
limitations of indicators in Parts II
and III
of this series.