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You Can't Become Rich In Your Pocket Until You Become Rich In Your Mind | ||||
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In contrast to the cold discipline of fundamental analysis, the pattern analyst's world reeks with lust and intrigueTHE HIDDEN MARKET The vast majority of destabilizing and supportive market energies remain hidden from individual traders. Insiders quietly manipulate news to protect options positions. Analysts push stocks so their trading departments can unload inventory. Operating failures pass through accounting magic and disappear. As a result, market knowledge has limited value unless it meets one important test: it must stand alone as a complete fractal image of all hidden and known information about that market. Traders and investors study markets through price charts. These powerful visual tools offer a common language for all equities, derivatives, and indices. The simplest chart just draws a timeprice axis and adds each day’s closing price as a single point or vertical bar. The connected data points then plot a series of oscillating highs and lows that participants study to predict whether price will move up or down over time. Pattern analysis begins with the simple observation that all market activity reflects itself in the fractal properties of price and volume. These small bits of information create a profound visual representation when tied together into a continuous time series: a display of both current and past outcomes for all interactions of infinite market forces as seen through the eyes of all participants. In contrast to the cold discipline of fundamental analysis, the pattern analyst’s world reeks with lust and intrigue. The markets are about money. No other controlled substance brings out the best and worst of humanity with quite so much intensity. The markets become our lovers, our bosses, and the bullies who beat us up when we were young. As assets shrink or swell, emotions flood in and cloud reason, planning, and self-discipline. Chronic fight-flight impulses emerge to trigger unconscious (and often inappropriate) buying and selling behavior. Actions initiated through emotional impulse generate oscillations in both price and time that print clearly on charts. The skilled pattern reader observes this unstable behavior and visualizes impending price movement. But successful trade execution requires both accurate prediction and excellent timing. Fortunately, chart patterns work without crystal balls or divine intervention. As a detailed map of all market forces, patterns identify exact trigger points where the swing trader can exploit the emotional crowd. Patterns simplify and condense a vast universe of market interplay into easily recognizable setups. The subsequent analysis actually evokes the subjective right brain processes rather than the cold analytics of the orb’s left side. Correct interpretation requires that the swing trader focus intuition on crowd impulses evident within each price chart. Those who divine correctly and apply that knowledge to obtaining profits are truly artists at their core, not masters of science. Edwards and Magee did not invent patterns for their 1948 classic Technical Analysis of Stock Trends. They observed an order within price movement as ancient as the auction place. They also recognized the existence of cyclical crowd behavior throughout all time frames and all markets. Although the individual components are simple and easy to understand, these repeating formations offer the most intriguing predictive methods in the entire financial world. PATTERN CYCLES The U.S. stock exchanges trade over 9,000 issues each day. Add to that many thousands of emerging exchanges and companies worldwide. On any given day, every bull and bear condition, from euphoria to panic, exists somewhere on the planet. Buried within this universe of volatility and price movement, perfect trade setups wait to be discovered. But how can the speculator consistently tap this deep well of profit without being crushed by information overload or burnout? For many decades, technical traders learned chart interpretation through the concepts of Dow Theory. Or they studied Edwards and Magee and faithfully memorized the characteristics of familiar price patterns seen daily on their favorite stocks or futures. These speculators were a minority within the investment community, and their size allowed them to execute effective strategies that capitalized on these little-known patterns when they appeared. Net connectivity revolutionizes public access to price charts. They no longer require an expensive subscription, and most market participants can view them quickly in real-time. Now everyone reads the charts and believes that he or she understands the inner secrets of technical analysis. As noted earlier in this chapter, common knowledge of any market condition closes the system inefficiency that allows easy profit from it. Triangles, flags, and double tops now belong to the masses and are often undependable to trade through old methods. Fortunately, the popularity of chart reading opens a new and powerful inefficiency for swing traders to manipulate. They can use the crowd’s limited pattern knowledge for their own profit. The new disciples of technical analysis tend to focus on those few patterns that have worked well over the past century. Skilled traders can place themselves on the other side of popular interpretation and fade those setups with pattern failure tactics. More importantly, they can master the unified structure that underlies all pattern development and awaken the skills required to successfully trade dependable setups that have no name or adoring crowd. Pattern Cycles recognize that markets travel through repeated bull and bear conditions in all time frames. Trends uncoil in a predictable manner, while constricted ranges print common shapes. Measurable characteristics distinguish each opportunity phase from uptrend to downtrend and back again. Most participants see these changes as the typical top, bottom, and congestion patterns. But a far richer trading world exists. The twin engines of greed and fear fuel the creation of market opportunity. Through their power, the crowd reacts in a predictable manner at every stage of price development. Prices fall and fear releases discounted equities into patient value hands. Prices rise and mindless greed bids up hot shares into the pockets of momentum players. On and on it goes through all markets and time frames. Rising prices attract greed. Paper profits distort self-image and foster inappropriate use of margin. The addictive thrill of a rally draws in many participants looking for a quick buck. More jump on board just to take a joyride in the market’s amusement park. But greed-driven rallies will continue only as long as the greater fool mechanism holds. Eventually, growing excitement closes the mind to negative news as the crowd recognizes only positive reinforcement. Momentum fades and the uptrend finally ends. Falling prices awaken fear. The rational mind sets artificial limits as profits evaporate or losses deepen. Corrections repeatedly pierce these thin boundaries and force animal instinct to replace reason. Negative emotions build quickly as pockets empty. Personality flaws invade the psyche of the wounded long while sudden short-covering rallies raise false hopes and increase pain. The subsequent decline finally becomes unbearable and the tortured shareholder sells, just as the market reverses. The emotional crowd generates constant price imbalances that swing traders can exploit. But successful execution requires precision in both time and direction. Fortunately, this chaotic world of price change masks the orderly Pattern Cycle structure that generates accurate prediction and profitable opportunities through all market conditions. This inner order frees the mind, provides continuous feedback, and empowers spontaneous execution of rewarding trades. Swing traders capitalize on the emotions of others after they control their own. Pattern Cycles caution them to stand apart from the crowd at all times. In the simplest terms it represents the attractive prey from which their livelihood is made. And just as a wild cat stalks the herd’s edge looking for a vulnerable meal, the swing trader must recognize opportunity by watching the daily grind of price swings, volume spikes, and market noise. Prices trend only fifteen to twenty percent of the time through all equities, derivatives, and indices. This is true in all charts, from 1-minute bars through monthly displays. Markets spend the balance of time absorbing instability created by trend-induced momentum. Swing traders see this process in the wavelike motion of price bars as they oscillate between support and resistance. Each burst of crowd excitement alternates with extended periods of relative inactivity. Reduced volume and countertrend movement mark this loss of energy. As ranges contract, so does volatility. Like a coiled spring, markets approach neutral points from which momentum reawakens to trigger directional price movement. This interface between the end of an inactive period and the start of a new surge marks a high-reward empty zone (EZ) for those that can find it. Prior to beginning each new breath, the body experiences a moment of silence as the last exhalation completes. The markets regenerate momentum in a similar manner. The EZ signals that price has returned to stability. Because only instability can change that condition, volatility then sparks a new action cycle of directional movement. Price bars expand sharply out of the EZ into trending waves. Swing traders use pattern recognition to identify these profitable turning points. Price bar range (distance from the high to low) tends to narrow as markets approach stability. Skilled eyes search for a narrowing series of these bars in sideways congestion after a stock pulls back from a strong trend. Once located, they place execution orders on both sides of the EZ and enter their position in whatever direction the market breaks out. Paradoxically, most math-based indicators fail to identify these important trading interfaces. Modern tools such as moving averages and rate of change measurements tend to flatline or revert toward neutral just as price action reaches the EZ trigger point. This failure reinforces one of the great wisdoms of technical analysis: use math-based indicators to verify the price pattern, but not the other way around. Volatility provides the raw material for momentum to generate. This elusive concept opens the door to trading opportunity, so take the time to understand how this works. Technical Analysis of Stocks and Commodities magazine describes volatility as ‘‘a measure of a stock’s tendency to move up and down in price, based on its daily price history over the latest 12 months.” While this definition fixes only upon a single time frame, it illustrates how relative price swings reveal unique characteristics of market movement. Rate of change (ROC) indicators measure trending price over time. Volatility studies this same information but first removes direction from the equation. It stretches waves of price movement into a straight line and then calculates the length. Volatile markets move greater distances over time than less volatile ones. But this internal engine has little value to swing traders unless it can contribute to profits. Fortunately, volatility has an important characteristic that enables accurate prediction. It tends to move in regular and identifiable cycles. As prices ebb and flow, volatility oscillates between active and inactive states. Swing traders can apply original techniques to measure this phenomenon in both the equities and futures markets. For example, 10-and 100-period Historical Volatility studies the relationship between cyclical price swings and their current movement. And Tony Crabel’s classic study of range expansion, Day Trading with Short Term Price Patterns and Opening Range Breakout, predicts volatility through patterns of wide and narrow price bars. |
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