Technical Analysis: Four Basic Principles

May 12th, 2010 | By | Category: General Comments
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We have all seen so many lists of trading rules that we sort of become numb to them. Even if they contain good advice (“always respect your stops”), they are so omnipresent in the trading literature and on Internet forums that we probably don’t pay as much attention to them as we should. I want to share a very different kind of list today. This is a list of what I believe are the basic principles of market behavior. This list is, in some sense, a list of what makes technical analysis work. We will encounter these ideas in future blogs and discussions, but today I just want to put them out there for you to start thinking about them.

I also should acknowledge my debt to the people who taught me. Over the years I had several mentors, and, frankly, I owe them a lot. This list is compiled from the teaching of several of these people, and I know they borrowed these ideas from the people who came before them. This really is one of those fields where, if we can see a little farther than everyone else, it is only because we stand on the shoulders of giants. Or, another way I like to think of this is that I have many great ideas, but very few of them are actually my ideas!

Markets alternate between range expansion and range contraction
Markets tend to exist in one of two phases: either trending or chopping back and forth in ranges. The problem is that trading tools that will work in one environment are exactly wrong in the other. Applying a strategy that is appropriate in a trading range (selling resistance or buying support) will get you killed in a trend. This is why the first step in any real market analysis is to quantify the most likely emerging volatility environment. (Read that last sentence over several times.)

Trend continuation is more likely than reversal
Countertrend trading can be seductive. We all love to catch the exact high or low of a move, and while it certainly is possible to make money this way, it is the hard money. Traders who focus on countertrend trading often get an emotional charge from “being right” and from “catching the turn”, but this approach often causes us to miss the really easy money in trends. Given a market in a trend, your best bet is always to bet on continuation of the trend.

Trends end in one of two ways: climax or rollover
There are predictable patterns to the ways trends end. Either the market just runs out of steam, resistance starts to hold, and the market rolls over. (This is the cause of the “rounding top” formation that some people are so fond of.) The other common way trends end is in a buying climax. The market goes parabolic as the last buyers are willing to pay practically any price to get in. Once that last buyer buys, a vacuum is created on the other side and the market collapses. As a funny aside, one of my very first trades was buying wheat futures in late April 1996 when I was sure it was going to the moon. (Check the charts if you don’t know that little piece of market history; we learn best from our painful mistakes!)

Momentum precedes price
This one is maybe the most important of the four. The basic unit of market movement is a move in one direction, a pause and smaller move in the opposite direction, and then another move in the original direction. This pattern repeats over and over in all time frames. This meaning of this rule is that when a market makes a sharp move (an “impulse” or “momentum” move), price is likely to continue further in the same direction. (Note that this doesn’t refer to indicators that measure momentum lead price; there are truly no leading indicators because all standard indicators are derivatives of price.)

Think about these rules and how they apply to the patterns you see and the trades you make. Whether you are establishing positions to hold for many months or scalping a few cents off the order flow in the tape, if you’re making money then you almost certainly are aligned with these principles. If you are not making money, then it might be helpful to rethink your strategies in light of these basic principles of price behavior.

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15 comments
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  1. “Momentum precedes price.” That’s what Linda Raschke has talked about again and again.
    Great, Aceman, your posting is much appreciated!

    Cheers,
    Markus

  2. “Momentum precedes price.” That’s what Linda Raschke has talked about again and again.
    Great, Aceman, your posting is much appreciated!

    Cheers,
    Markus

  3. in light of recent market events, would you include panic and confusion to the list? looking at most 15 minute charts going back a week, nothing seems to be acting right “technically”

  4. in light of recent market events, would you include panic and confusion to the list? looking at most 15 minute charts going back a week, nothing seems to be acting right “technically”

  5. I’m loving your posts Aceman! Really great stuff, thanks for posting. Are you follow-able on Twitter, by chance?

    I don’t think I’ve ever posted a comment here before, though I’ve been reading the blog religiously for well over a year now (maybe two years?!). I love the stuff you guys put out, I have learned so much from you all (I can’t thank you enough for all the Stocktwits TV episodes). I attribute much of my success to the lessons I’ve learned from the SMB bloggers/hosts; I dare say I now trade the ‘SMB style’ with consistent success. So thanks to all of you for that! And now, Aceman’s posts are pushing the content here to a new level. I’m loving it!

  6. I’m loving your posts Aceman! Really great stuff, thanks for posting. Are you follow-able on Twitter, by chance?

    I don’t think I’ve ever posted a comment here before, though I’ve been reading the blog religiously for well over a year now (maybe two years?!). I love the stuff you guys put out, I have learned so much from you all (I can’t thank you enough for all the Stocktwits TV episodes). I attribute much of my success to the lessons I’ve learned from the SMB bloggers/hosts; I dare say I now trade the ‘SMB style’ with consistent success. So thanks to all of you for that! And now, Aceman’s posts are pushing the content here to a new level. I’m loving it!

  7. Steve:

    Great blogpost. I would like to learn more about market principles and technical analysis.
    Could you point me to any website/books/blogposts that contain more useful info similar to your post.

    Regards,
    Tapetrader

  8. Steve:

    Great blogpost. I would like to learn more about market principles and technical analysis.
    Could you point me to any website/books/blogposts that contain more useful info similar to your post.

    Regards,
    Tapetrader

  9. Aceman:

    Oops, my inital post was directed to you not steve, I incorrectly assumed that all posts titled “technical analysis” are written by him, since he has written so many, lol.
    Nice post, and keep up the good work.

    Tapetrader

  10. Aceman:

    Oops, my inital post was directed to you not steve, I incorrectly assumed that all posts titled “technical analysis” are written by him, since he has written so many, lol.
    Nice post, and keep up the good work.

    Tapetrader

  11. Thank you all for your kind words about my blogging efforts here. It has been a very constructive challenge for me to sit down, organize and condense my thoughts into a format that might be useful for someone else. if anything is unclear or confusing, please ask and i’ll try to clarify.

    @tapereader: I actually don’t have a good answer to this one. I have read hundreds of trading books and gotten at least one good idea from most of them. There are a lot of great trading blogs, but I actually dont know of any that cover what I would consider to be deep background stuff like I’m trying to do. I guess I think everyone should read Jack Schwager’s big red book on Technical Analysis. (It’s titled TA of the Futures Markets, but applies to all markets.) Let me think about that question a little more.

    @skytrader: My twitter name is AHGrimes. I’m not currently tweeting but will start soon.

    @eric: This is a good question. I would say that the price spike was crazy and no analytical methodology could have seen it coming, but the action afterwards has been textbook. My expectation was for contracting swings and difficult trading… and we got both. A good technical tool set lets you quantify the fear and panic to some extent. There actually probably should be another rule saying that “markets overreact”… maybe we’ll add that one.

  12. Thank you all for your kind words about my blogging efforts here. It has been a very constructive challenge for me to sit down, organize and condense my thoughts into a format that might be useful for someone else. if anything is unclear or confusing, please ask and i’ll try to clarify.

    @tapereader: I actually don’t have a good answer to this one. I have read hundreds of trading books and gotten at least one good idea from most of them. There are a lot of great trading blogs, but I actually dont know of any that cover what I would consider to be deep background stuff like I’m trying to do. I guess I think everyone should read Jack Schwager’s big red book on Technical Analysis. (It’s titled TA of the Futures Markets, but applies to all markets.) Let me think about that question a little more.

    @skytrader: My twitter name is AHGrimes. I’m not currently tweeting but will start soon.

    @eric: This is a good question. I would say that the price spike was crazy and no analytical methodology could have seen it coming, but the action afterwards has been textbook. My expectation was for contracting swings and difficult trading… and we got both. A good technical tool set lets you quantify the fear and panic to some extent. There actually probably should be another rule saying that “markets overreact”… maybe we’ll add that one.

  13. Aceman,

    Maybe you can add it when you write the epic blog titled Technical Analysis in today’s HFT market! Thx for the good info.

  14. Aceman,

    Maybe you can add it when you write the epic blog titled Technical Analysis in today’s HFT market! Thx for the good info.

  15. Adam, thanks for your post. One question, what do you mean by, “emerging volatility” and How you quantify it?