Apr 2006
This is the third article in a series. For part II click the following, What's Wrong with TA. For part I click here.
In his book Trade Your Way to Financial Freedom, Dr. Van K. Tharp offers an interesting perspective:
Until now, you've probably thought that a daily bar chart really was the market. Remember, all you're really looking at is a single line on your computer or chart book. You are assuming that it represents the market. You might call it a generalization about the market's activity on a given day, but that's the best you can call it. The scary thing is that a daily bar, which is at best summary information, is typically the raw data that you manipulate to make your decisions.
...You could just trade bar charts. But most people want to do something with their data before they trade, so they use indicators. Unfortunately, people do the same thing with market indicators. They assume they are reality, rather than attempts to represent something that might occur.
So many people look at a chart and think they are viewing something real. They are not. They are looking at pixels on a screen or dots of ink on a page. The chart is not reality. It is merely an abstract representation of what has happened to two variables (price and volume) over a defined time period.
When I say that people think charts are ‘real,' that doesn't mean there is philosophical contemplation involved. It means that undue emphasis is assigned to a collection of squiggly lines, and it is usually done without conscious thought. We forget that the chart was meant to represent something else in the first place. This can lead to all kinds of errors, many of which play on the natural human tendency to assume meaning where there is none to be found.
Think about this. Bar and candlestick charts are the most popular way to represent price patterns; but, theoretically, price patterns could also be represented by sound.
Based on a series of melodic transitions, rising and falling notes could stand in for the up-and-down motion of the daily bars. So, when you hear a prolonged bass note that keeps getting deeper, that would mean the market is falling lower. An escalating crescendo could mean the market is rising higher -- perhaps into a blowoff top. Changes in auditory volume (how loud or soft the sound is) could correspond to fluctuations in share volume. A dramatic "spike" in musical pitch could correspond to a spike in price up or down.
It might actually work pretty well; with enough practice, most anyone could "see" a chart with their ears, and assign labels to recurring sound patterns.
And yet, if someone were to hand you a CD of "market melodies," you would probably think it was Looney Tunes. (Ha ha.) Would you be tempted to imagine those melodies as ‘reality' in the same way that you (or at least many of you) subconsciously perceive a chart to be ‘reality'? Probably not.
We are more likely to think of charts as "real" for a few reasons. They are deeply familiar, they are visually oriented, and in terms of day to day reliance, sight tends to dominate the senses. To "see" a chart is to assume that "what you see is what you get." Hearing a chart, on the other hand, is perhaps odd enough to break the spell.
Speaking of what is and isn't reality, there is a great line from the Matrix, that movie about a virtual reality world created by sentient machines. Two humans are hanging out in the real world (as opposed to the virtual one they occasionally run around in), watching endless lines of green computer code running down a screen. "I don't even see the code," one says. "All I see is blonde, brunette, redhead..."
The point is that you can look at an abstract representation of data and "see" something else entirely -- or even "hear" something else entirely -- if you have creative access to the reality it represents.
Here's another example. When a non-musician looks at a piece of sheet music, all they get is a bunch of symbols. Funny-shaped notes in wavy patterns. But when a classically trained pianist looks at that same piece of music, she can actually "hear" the melody in her head. She naturally translates the notes into music; which, of course, was the composer's original intent.
So where are we going with this?
In many ways, the previous three problems discussed -- TA confusion, TA distraction, and TA false confidence -- are all rooted in the problem of overemphasis on a narrow broadcast of information, which in turn is rooted in a tendency to give the chart more concreteness than it actually deserves.
When you fully and truly recognize that the chart is not reality itself, but only a limited slice of abstraction -- one compacted source of information among many -- it opens your mind to a bigger picture.
Just as a trained musician can hear music emanating from a silent page, a trained market participant can look at a chart and experience the battle of bulls and bears, undulations of fear and greed, and so on. But in order for that to happen, you can't get hung up on the squiggly lines... just as a musician can't get hung up on the shape of the notes. Instead of stopping with a pattern, charts can offer up a mental glimpse of the more complex reality that created that pattern. By recognizing that the chart itself is not ‘real,' you gain greater access to the reality it represents.
To use a chart in the way I'm talking about -- to look beyond the bars -- your imagination and experience must come into play. You must recognize the various possibilities represented by what you see.
For example: Say that you are scrolling through the charts on your watch list, and you come across an interesting looking breakdown on significant volume, with important trend lines and key moving averages violated. What does this mean in terms of future movement? Here are a few possibilities:
A) The bull run for this stock is over.Previously bullish institutionals and insiders are now selling out. A new downtrend is in the cards, likely to be sustained over the next few weeks or months.
B) The tide of hot money previously driving this stock's sector or industry just receded, thanks to a bit of news that may or may not be important two weeks or two months from now.
C) The weak hands in this stock just got washed out on an overreaction triggered by heavy program trading, and savvy investors will soon be buying in with both hands at these temporarily reduced levels.
D) The uptrend is dead, but calling a downtrend is premature. The stock is headed for dullsville as a period of sideways chop kicks in.
Which one is it? A, B, C, or D... or maybe another scenario entirely? The chart cannot tell you in isolation. How about the oscillators? Are they any help in determining with certainty what might happen over the next few weeks or months? In an information vacuum, probably not.
The fact that an uptrend was violated may be a useful piece of information in and of itself, and a factor of psychological weight in and of itself, but without the surrounding context, you can't do much with it. (Traders who act purely on technical patterns may disagree with this; but note that the more simplistic one's entry signals are, the more restrictive one's range of instruments must be. When the market moves up, you can't buy 20 day breakouts on 247 different stocks. Or at least you wouldn't probably want to. )
As Bruce Kovner observed, "You have to use your own intelligence to draw conclusions about what the past activity of some traders may say about the future activity of other traders."
This is also similar to what Jesse Livermore said nearly a century ago, in his unofficial biography Reminiscences of a Stock Operator:"You have to use your own brains and vision to do this, otherwise my advice would be as idiotic as telling you to buy cheap and sell dear."
If a chart could talk, its advice might compare to Livermore's friendly sarcasm. The chart gives you direct insight into what is happening now (or rather, what has happened just now), but your own brains and vision are required to determine what today's bearish (or bullish) event really means for tomorrow.
Still to come: What's right with TA and why, in spite of the pitfalls, technical analysis can still be highly useful and potentially indispensable when utilized correctly. The role that TA plays in a comprehensive trading / investing methodology. Also still to come, delving into the three elements of triple V analysis-Velocity, Volatility and Volume-and further exploring the thought processes that set triple V apart.
