The Psychology is My Problem

Every ship at the bottom of the ocean has a set of
charts on it.
—Old nautical saying

When I first started trading in May 1986, the first book I read on the markets was Chart Your Way to Stock Market Profits, by David L. Markstein (New York: Arco Publishing, 1972). I have since lost the book and I couldn’t find it again searching the Web. I probably threw it out, now that I have a better grasp on what I am doing every day. About the only thing I remember about the book was how intoxicating it felt to read something for the first time that provided me with such a simple solution to my goal of getting rich in the markets. I was too uneducated (some would say naive) to understand that it wasn’t going to be that simple.

There were numerous books and services available for people interested in trading equities, but there was very little data available specifically for traders interested in futures or options. The cash FOREX markets were the exclusive domain of banks and private investors, so that market wasn’t even available. For me as a new trader, the best course of action was to actually go to work in the industry and learn the business from the inside out. So I did.

After I began trading—and accumulating losses—I continued to ravenously devour anything I could find on market analysis. At the time, the alleged science of technical analysis was still in its infancy. Most of the technical indicators that are used by traders today were just concepts.

Commonly used indicators such as Williams %R, MACD, and the commodity channel index (CCI) had not been developed or were not licensed to all the available charting services. Many indicators were formulas you had to compute manually and then physically mark the results on a paper chart. At the time, having a real-time data feed from the exchanges was very costly and required dedicated computer hardware. There was no online access to information like there is today, and you needed an actual broker available to place trades and report fills. All of what we take for granted today as a professional-level, online market presence literally had not been invented yet; and this was only 20 years ago. (As a side note, I actually met George Lane, the developer of stochastics, at the Chicago Board of Trade just after I began working full-time in the markets in 1987. He was considered a god at the time.)

I continued to read, study, chart, and trade for years, spending huge sums of money on real-time data feeds, books, audio courses, charting services, live seminars, and so on. During this educational experience, at no time did any of these self-created gurus ever mention that the futures and options markets were zero-sum transactions. The only exposure I initially had to the concept of zero-sum transactions was when I passed my Series III brokers exam. I didn’t know how critical that information would be until after I had my first blowout. In fact, when I teach my “Psychology of Trading” seminar today, there is always at least one person in the audience who has been trading for years but has never even heard the term and has no clue what it means. The inherent nature of zero-sum transactions makes analysis of the markets a very different thing than the analysts and chartists would have you believe.

During this part of my development as a trader I continued to have net losses. I searched and searched for the cause of my losses, believing, like most novices do, that the problem must be at least in part due to how I was doing my analysis. What made this period so frustrating for me was that the root problem was exactly that—how I was doing my market analysis—but real analysis of the markets has very little to do with technical analysis or technical indicators. Knowing that difference is what made all the education come together for me. You need to know that difference as well, or your results will remain net losses, because zero-sum transactions cannot be mathematically analyzed nor predicted with any certainty. Proponents of technical analysis methods will have a field day with that statement, but I am going to show you something that will help you understand that the limits of technical analysis, when properly viewed in the context of zero-sum transactions, are the very thing that makes it valuable.

The very nature of zero-sum transactions means that exactly 50% of executed contracts have profit potential. Once the net order flow has moved the traded price away from the executed entry, it is impossible for both of the open positions to show a profit. Without advance knowledge of the net order flow, your actual mathematical probability for a winning trade once you have executed for your entry is 50%. Bear in mind, I am not using any trading hypothesis, analysis, or previous support/resistance information.

I am merely stating the fact that once the market moves, you will have either an open-trade profit or a loss at that point. We are not discussing the market “coming back,” the potential to make a new yearly high/low, chart formations that have probabilities, or anything else. I am saying that from a mathematical point of view, it is impossible for everybody to be right.

The idea behind technical analysis is that by somehow combining or dividing previously traded prices, overlaying a type of constant algorithm to previously traded prices, comparing previously traded prices to some formula, and so on, you can thereby arrive at a number that the market has a potential to reach, predict the market will change direction, or be confident that it will continue in the same direction. The seduction of your will is now complete and you place yourself at risk.

But the market continues to move for the only reason that it will ever move—because of the net order flow. Most traders now believe that if you have an open-trade loss after this mental dance of technical analysis has been done, somehow the analysis was not done correctly—otherwise, they would have been on the other side or waited. This illusion is what most traders operate under for the entire life of their trading career. The more firmly entrenched a trader is in this illusion, the greater amount of study or analysis he will do or the greater amount of money he will spend trying to develop a better technical approach.

The important bedrock understanding you as a trader need to have about technical analysis is that it is not predictive; it is historical. Technical analysis cannot predict price action because it is mathematically impossible for everybody to be right in the first place, and everyone has the same technical analysis available to them.

A price chart with a 21-bar moving average and stochastics on my desk is identical to your price chart with a 21-bar moving average and stochastics on your desk. If we both conclude the same thing—that this data predicts a price rise, for example—and every other trader in the world using that same technical analysis sees the same thing we have been taught to glean from it, and we all decide to buy because we trust the analysis, the only way we can get into that market is if someone sells to us. What is the seller using to conclude that the time to get in is also now but that the market is poised to move lower? What is his analysis based on?

The really seductive part of this whole process is that if the trade makes a profit, the trader assumes the analysis works. That is the conclusion most traders will come to. The only reason the trade worked is because the net order flow was from that side, but the trader concludes it was the analysis that found the trade. Once the analysis works one time, the trader extrapolates that to mean it will work all the time. If using the exact same analysis again results in a loss, the trader assumes the fault was in how the analysis was done. In other words, the crystal ball wasn’t plugged in this time. But the trader is still convinced that he owns a crystal ball.

If you do your homework you will discover that any form of technical analysis has some level of probability of finding a winning trade. For the most part, all technical analysis or mathematical models developed for systemized use have a success rate between 38% and 52% winning trades based on the predictive hypothesis used by the developer. That is no better than chance. If you flip a coin 100 times you will have 52% heads or tails, or some random bell curve distribution based on probability theory.

In fact, the entire industry based on this predictive illusion of technical analysis is very proud to document to you the winning trade to losing trade ratio of the system in question. If you want a real eye-opener, just count how many of these high-tech, systemized approaches have win/loss ratios lower than the 35% range, which is actually less than flipping a coin.

What are these people thinking?
Since technical analysis will only help you 52% of the time at best, why would you trust it 100% of the time? Answering that question and really thinking about what you are doing is the key to following this rule. You must know the limits of your analysis and what the analysis is really saying in order to use it successfully.

In my opinion, the simplest way to effectively use technical analysis is to look at it from the loser’s point of view. Proper analysis of your market starts with the understanding that not all of the participants are going to be winners. The loser is in there somewhere and he must liquidate at some point. Looking at the market price action from the point of view that the loser is in there, thinking and trusting something that allows him to place himself at risk, puts you in a position to anticipate potential net order flow when it is about time for the loser to quit. Your best analysis is done by asking the question, “Where is the loser?”

The last thing you want your analysis to do is attempt to predict price action. You want your analysis to disclose historical information. You want information that discloses where the loser is, what he is most likely thinking, and where he will most likely be forced to liquidate the losing trade. You already know that the loser has trusted some form of analysis, he is using it to predict price action, and he can’t be right. Armed with that point of view, you need to assess at what point a loser would come into the market and where he would most likely liquidate. All of your technical analysis is best used to help uncover where the loser is and what he is most likely thinking in order to continually keep placing himself at risk.

Your analysis is best used to help you understand what has already happened and then help you deduce what must happen next. This is a different process than predicting price action. The process of critical deduction, intuition, and knowledge combined with the question “Where is the loser?” is not predictive. You really don’t need to answer the question, “Which price is coming next?” You need to answer the question “Where and when will the loser quit?” Before we conclude this discussion on the limits and usefulness of technical analysis, I think it is best to make a few things clear so no one gets the wrong impression. I am not saying that technical analysis is bad or that it is without value. There are many parts of technical analysis that are very useful and should be part of a well-rounded trading methodology. I think you would be best served in your use of technical analysis if you would not trust it implicitly to find winning trades. I believe that it is best used in conjunction with sound knowledge of what ultimately drives prices.

Net order flow can only change if someone is certain enough that he will make a winning trade and he is willing to initiate a position to find out. Regardless of all the little nuances that happen around the net order flow or the degree of probability one kind of analysis has versus another, the bottom line is that only a fraction of open contracts will be on the right side of the price action long enough to have a profit. Technical analysis is designed to uncover this inequality, but charts cannot tell you what will happen. Charts and analysis can only provide a detailed history of what has already happened. It is up to the trader doing the analysis to deduce what is most likely to happen next from that historical information.

This article is a part of “trading rules that work” ebooks for closed private education purpose only.

TimesOnLine

From The Sunday Times
August 31, 2008
Jennifer Hill on Capital Hill

Investing is like a voyage into the unknown: no-one can say with certainty how a stock or sector will fare in the future. Professionals who identify the performers of the future are rewarded handsomely with company bonuses and performance fees that eat into investors’ returns. They use all manner of techniques to pick stocks: pouring through screeds of company accounts, analysing cash flow and business plans to determine how these firms will fare.

Some ordinary investors, though, are making money purely from charting share price past performance rather than developing any real knowledge of the businesses involved.

While some chartists work out their own algorithms to analyse patterns — this requires a strong maths ability — most download software free from the internet, then subscribe to updates (for about £200-£1,000 a year).

Carole Howorth, at Lancaster University Management School, studied 20 chartists, a dozen of them in-depth.

Albert (Howorth only uses Chritian names — some of her subjects are eminent City analysts) uses “black-boxing”, a systematised method that requires little or no interpretative activity. Chartists in this group don’t commit significant resources to developing their skills, but rely on the basic analysis of others.

While fellow black-boxer Nigel uses “relative strength index”, a mainstream technical indicator available on virtually every technical analysis software package, Albert simply subscribes to a newsletter, then watches the recommended shares on a basic end-of-day charting programme.

“If the graph is going like the north face of the Eiger, I may well buy and I’ll hold those until they drop; I only buy shares when they’re going up,” says the busy family man, who rates it his best method in 15 years of investing.

Then there are number-crunchers. These chartists use a range of devices from looking at simple share price moving averages to “Ichimoku”, a Japanese technique that draws a cloud beneath or above a stock chart, designed to help investors spot trends.

“The charts will tell me what I need to know and if it looks interesting, either because it’s going up or going down, whether it’s worth investigating further,” says number-crunching Tony.

Mickey is a wave-surfer. He uses Fibonacci, an automated method that, simply put, searches for patterns of price movements. “It’s dead easy,” he says. “I select Fibonacci, click once on a high point, once on the low point and the lines are automatically drawn.”

Max, by comparison, is a relative beginner with less than a year’s trading experience. Frustrated that his losers outnumbered winners, he turned to chart-seeing. He scans a universe of 200 stocks, limited by his chosen specialism of US equities, to decipher trends.

So, how did they do? Five of the 12 studied at length had a high success rate, beating the market over a year, says Howorth’s study, to be published in the Accounting, Organisations and Society journal. Four matched the market and three underperformed.

There were no clear delineations. In the high camp were Albert and two other black-boxers, number-cruncher Tony and a wave-surfer. Chart-seeing Max and one from each of the other three categories had medium performance. Wave-surfer Mickey, a black-boxer and a number-cruncher had low success. Clearly this, like the techniques of the professionals who often deride charting as “voodoo finance”, is not an exact science.

Jennifer Hill is deputy editor of the Money section

This stock trading video is one of the most popular in the “How To Trade in 90 Seconds” series produced by MarketClub.

As the greater social mood turns more negative, the financial markets reflect that mood with the deepening bearish trend we see now. That’s the crux of socionomics, the study of human behavior based on the Wave Principle, as introduced by Bob Prechter. Positive social mood engenders peace, love, understanding and bullish stock markets. Negative social mood engenders war, hatred, miscommunication and bearish stock markets.

Being ever hopeful and optimistic, most Americans figure that something will happen to fix our economy and financial system before they deteriorate any further. Perhaps a new Administration will solve the problems, we tend to think, particularly since we are in the final two months of the campaign to select a new U.S. president. But Prechter says, be wary of such thinking. When the overall social mood changes to negative, no one person – no matter how powerful – can change it. Here’s an excerpt from his latest Elliott Wave Theorist that lays out his reasoning.

Excerpted from The Elliott Wave Theorist, August 2008

What if something happens in the political realm to change the bearish trend?

On the contrary, events on the political front are right in line with our socionomic expectations. As social mood has trended further toward the negative, social conflict has been rapidly increasing. [In mid-August], Russia attacked Georgia, and President Bush delivered yet another stunningly belligerent statement to a foreign government, this time to Russia: “The United States [government] … insists that the sovereignty and territorial integrity of Georgia be respected.” (AP 8/14/08) This statement continues a string of Bush administration ultimatums and threats previously delivered to Iraq, Iran, Afghanistan, Pakistan, Syria, Libya, Turkey, Ukraine, North Korea, Venezuela and China.

[Then] the administration upped the ante by pledging anti-missile technology to Poland, incensing the Russians further. Not since 1940, in the last Supercycle bear market, has a U.S. administration been so hell-bent on going to war. Of course, a great number of U.S. citizens are vehemently of the same mind, which is why Bush’s popularity rating soared to 91 percent when he ordered the invasion of Iraq. This mood is exactly what socionomics predicts for bear markets.

Putin is in the same chest-puffing league as Bush, not to mention potential successor McCain, who has demanded—despite his utter lack of authority—that Russia “unconditionally cease its military operations and withdraw all forces” from Georgia. He added, “In the 21st century, nations don’t invade other nations,” forgetting that the U.S. government invaded Iraq, fostering death and havoc in the Middle East for five years. If Obama gets elected, he is not likely to avoid confrontation, either, because McCain has tagged him as weak, so he will strive to prove otherwise.

Today’s politicians, at our peril, ignore the Founding Fathers’ admonition to avoid foreign entanglements. So, whatever your proclivities, get ready for far more war risk in your personal life.

Short Answer: An Opportunity.

By Euan Wilson
Tue, 26 Aug 2008 17:00:00 ET

A lot can happen in a week, especially in the commodities markets.

That’s why Senior Commodities Analyst Jeffrey Kennedy writes the Daily Futures Junctures Weekly Wrap-up each Friday. Jeffrey uses these updates to review and post forecast charts for every major commodity market. He also records a video update which allows him to talk about each one of his charts in depth.

Jeffrey’s Weekly Wrap-Up is hugely popular among his subscribers and its very easy to see why: he not only covers everything but does so with a concise, effective efficiency. Its all part of Daily Futures Junctures, a pillar of our Futures Junctures Service.

By way of example, here’s an excerpt of last Friday’s update, with Jeffrey discussing what the week’s action in Soybeans means for the future:

“Soybeans have been challenging to label over the past week, and I’ve spent a lot of time going back between looking at the combined session charts and the pit session charts. I do so to get a good feel of clarity and substructure of a market.

“So what I think is going on now with Soybeans is that we have an initial move … for wave (-) … a secondary … for wave (-) …, and that subsequent price action is tracing out a diagonal triangle. That would actually make a lot of sense…. It would also bring it near … a retracement of a previous larger degree wave…

“Diagonal triangles are very exciting wave patterns. They often lead to swift and sizable swings in price, so … I’ll be watching this market very carefully.”

Jeffrey is correct: contracting triangles in wave counts are very exciting. What’s especially exciting here is that Soybeans have continued to unfold in line with Jeffrey’s contracting triangle label: prices have been moving inside a steadily smaller window, both today and Monday.

This means that Jeffrey’s call for a “swift and sizable swing in price” should now be in the cards – and soon. Where it is going is the more difficult question, but Daily Futures Junctures subscribers will have their answer no later than Friday when the next Weekly Wrap-up airs.

So why not become one of those subscribers and get the answers straight from the source? Elliott Wave International’s Futures Junctures Service delivers top-notch forecasting combined with just the right level of technical education and know how. Join us today.

[Ed. More Elliott Wave on Beans]

A MarketClub video about using their proprietary Trade Triangles for trend, entry and exits in crude oil.

Soybeans got into the action, trading lock limit up several times off a perfect Elliott wave low before ultimately smacking into perfect resistance.

The Market Oracle
http://www.marketoracle.co.uk/Article5999.html

[Ed. I love Elliott Wave analysis but absolutely hate doing the counting. When we find decent Elliott Wave charts we’ll post them. It’s a whole lot easier to pick up on a count and update it in the shorter time frames than to do all the grunt work from the beginning.]

Can you learn to trade Forex in 90 seconds?

Adam Hewison, president of INO.com and co-creator of MarketClub shows you how to analyze the Forex market in 90 seconds flat by using MarketClub’s proprietary “Trade Triangle” technology.

When looking at the foreign exchange markets we use the weekly triangle to identify trend (also possible initial entry). We can see that the EURO/USD has been in a positive weekly trend since early September (2007). Therefore, we would only be taking long positions.

We would use our daily “Trade Triangles” for timing. We use corresponding triangles as entry points and non-corresponding triangles as exit points. In about 1 month we turned this into a 427 pip profit.

The “Trade Triangle” technology helps traders enter markets after a steady trend has been established and only exit after the trend has come to a complete halt. This proprietary study can provide as a great tool in conjunction with other technical indicators of your choice. MarketClub also gives you access to multiple scans, historical data, news portfolio and a whole lot more.

If you are a member consider this video a quick refresher. If you’re not a member, join today and learn how MarketClub and our “Trade Triangle” technology can help you hunt down profits in the FOREX markets.

It only takes 90 seconds to sign-up for your 30-day risk free trial!

ShareCast UK
http://www.sharecast.com/cgi-bin/sharecast/story.cgi?story_id=2299808

By Michael Hewson

Thu 28 Aug 2008
LONDON (SHARECAST) - For the past 2 years Sterling has enjoyed heady status against the USD being in close proximity to the $2 mark since 2006. Some commentators are now predicting that it is now heading to $1.50 over the course of the next few months. I guess these are probably the same commentators who were predicting Gold at $2000 an ounce and Oil at $200 a barrel by the end of the year! Where do people get these figures from - at least in Sterling’s case there is historical precedence on their side - but Gold and Oil! Do these pundits lick their fingers, stick them above their heads and pull these numbers out of the air!

Historically Sterling does tend to fall very quickly as evidenced historically in 1991 and 1992 but things were a little different then with interest rates being artificially high amongst other factors.

At the moment we are in the midst of a worldwide credit crunch and every country is suffering. Speculators are currently selling Sterling on the basis that the Bank of England will have to cut interest rates by the end of the year as inflation declines and growth stalls. So let’s look at the interest rate differential – currently the 3 month differential between GBP rates and USD rates is 2.75% in favour of GBP which means that being short of GBP is currently quite expensive and will continue to be so until the BoE actually cut rates. This differential is double what it was in December last year when Sterling was trading around 1.9800 and the 3 month yield differential was 1.35%. People were quite happy buying it then.

The only thing that has changed since then is that America’s problems have filtered out into the Global Economy and now Europe and Asia are catching a cold as well.

The question that needs asking is whether the UK’s problems are worse than any other country or region and that is open to debate. The key support levels on Sterling are at 1.8305 and 1.7420 which are the 38.2% and 50% retracement levels of the move from 1.3685 to 2.1160 up move.

In conclusion given the current yield differential, talk of a Sterling move to $1.50 is somewhat premature and an attempt to try and grab headlines with a view to making the most extreme predictions. Certainly a move to 1.7420 is likely, however $1.50 is a bit of a stretch at this time. The USD is also recovering against the Euro and given those predictions we would be talking Euro down to €1.25/1.30 and possibly Gold back to $700 an ounce.

InternetNew
http://www.internetnews.com/bus-news/article.php/3768171s

The Dow and S&P are getting wound up for a big break. Which way will it be?

The Dow and S&P (first two charts below) are winding up in a tight trading range here. Which way will they break?

On the plus side, both indexes are holding some semblance of a rising channel, which holds the possibility of further gains. But both have been stymied at a downtrend line off the highs set earlier this month. A move above today’s highs of 1285 (SP Chart) and 11,554 could be good for some nice upside, while a move below 11,400 or 1270 could create room to 11,200 and 1250.

Paul Shread is a Chartered Market Technician (CMT) and member of the Market Technicians Association.