May 9, 2016 – The Many Ways of Analyzing Price Movements (Newbie Series)

In our previous post entitled “For Anyone Who Hasn’t Heard of the Markets”,we learned that charts are visual representations of price movements for the sole purpose of convenience of whether the price change is going up, down or sideways.  We will tackle that question more in-depth.

If it is not yet any clear, the ability to determine whether the prices are going to go up, down or sideways will help you determine as well whether you should buy today, later in the day, or tomorrow or next week.  The ability to know where the prices are going to head towards will make you a successful trader and that’s how money can be made in the markets.  People have devoted their lives in the pursuit of simply knowing about price movement because if they can assure themselves that the price of oil will go up tomorrow by a dollar, then they will buy today and sell tomorrow assuming that it will be worth more than the cost of doing so.  Most forex firms allow you to trade commodities for a 5 centavos spread.  As long as you can hit your target of 100 centavos within a day, then you’d be willing to pay that 5 centavos spread to your currency broker.  Do this consistently and you can call yourself a profitable oil futures trader.

What Affects Price Movements? 

We know already that roses go up in price during mother’s day because of a simple concept that there are many buyers all buying on that day.  However, what if it wasn’t flowers and what if it wasn’t Mother’s day?

Does it matter what affects it or not or that it happens?   For the purpose of answering that question – people will say that what affects price movements is simply supply and demand.  What affects the supply and demand can be about the historical weather patterns collectively known by some as Fundamentals.

For others, it matters to them mainly because they think that the prices will move based on a historical past and will continue to happen in the future.  For instance, if people love buying roses during Mother’s day, isn’t that a behavior that can always repeat every single time?  We call that a habit.  In market lingo, we call it a cycle.   We will not delve in this post what causes the price movements.  We will cover here however the fact that cycles exist in the market place.  

Concept 1:  A cycle is a price movement that is expected to occur within a specific time frame.  This expectation can be rooted from our historical evidences of what prices have done in the past.  It is based on an empirical observation spanning millions of information (price data) and spanning different market conditions.  

Any trader must first accept that prices move in cycles.  There are many reasons on the exact nature of cycles but we will not explain this.  (Fundamentals are on a different article.)  For now, it is only important that there are REPETITIONS.  People collectively believe that traders have an emotional cycle.  There are waves of optimism followed by down waves of pessimism.

We’ll define Market Condition first.

A Market Condition is anything that alters or influences your decision to buy or sell that specific good.  Maybe you’re in a festive mood.  Maybe you’re just euphoric today and decided to buy a lot of roses to surprise your loved ones. While people would generally classify your mood swings as sentiment indicators (another technical indicator) – anything that we can observe empirically – can be charted.  Your voting preferences can be charted – and so forth.

Expanding on our examples that many things influence a transaction – just think of yourself for a minute or two – even in a Mother’s day event, do you expect to sell ten million roses on that day if there were only ten people in the area?  Are they wholesale buyers who can afford buying one million roses each?   If it was Mother’s day but we were at war, do you think any transaction among roses will ever happen?  If it were Mother’s day but we were living in a desert where cacti are the only ones that are available, would the price of roses remain the same?  That’s what market conditions ultimately mean.

Once upon a time, properties in Hong Kong were always expensive – however SARS happened  in 2005 and it spurred panic and fear in the hearts of the people.  The Market Condition = Fearful.  People were afraid of living in Hong Kong because they feared for their lives.  There were SARS masks everywhere and the contagion of the disease affected the perception of the people that it was safe to live in Hong Kong.

Safety is an important criteria when people buy properties.  That’s a market condition.

Why is political climate important when some people assess buying stocks?  Why do you think?  Because it influences the market condition.  When everyone fears for their safety , they would not have any good reason to invest their money buying properties in the area.  Which do you believe is a more expensive property?  The developed market in Manila or the undeveloped forests in Mindanao.

The markets are pretty much the same way.

We may believe that a cycle is as simple as day and night.  The sun is expected to rise approximately 5am Philippine time every single day while it is expected to set approximately 5pm Philippine time.  Although these things have a tendency to not always happen every 5am, we can surmise that the discrepancy will be one hour early or one hour late – approximately 95% of the time.  Weather can be forecasted because it has a habit.  Just like the weather, prices are “forecasted” because each stock has a habit when you evaluate it with many price observations.

5pm and 5am are your average rising of the sun and setting of the sun times.  This refers to the VWAP or volume weighted average price that people are expecting the price to settle for that day.  The 1 hour discrepancy is called the range of the high and the low of that day’s price.  You can call that standard deviation or average true range or a band.  It has more importance the more frequent this observation is.  If Filipinos can forecast the time that the sun rises with perfect accuracy, perhaps it means nothing.  However, for traders – price accuracy can lead to millions.  However, the reason why Filipinos and everyone in the world forecast the weather is for such larger reasons – calamities.  Too many Filipinos died during the Ondoy and the Yolanda.  Disaster Risk Management council places hundreds of millions of pesos just to prevent a life from dying due to ill preparation to fighting a calamity.    You realize that it is a life and death situation for the Kidapawan farmers to prepare for the El Nino.  Forecasting weather conditions is studied because it affects millions of lives.  Although you will not die physically for not understanding the market cycle, you will die financially.

Concept 2: Price Movements Can Be Forecasted Based on Behavior or Patterns.  Standard Deviations and Average True Ranges are simply a few of the many examples of how a price movement can be studied.  This is actually called a ranging indicator.  There are indicators that measure how strong an uptrend can last, how high historically the stock can move before it retraces and where it will stop .  The important concept to understand is that price movements have habits and patterns and the best we can do is to use these odds as our edge in defining what to do with the present situation. 

Concept 3:  Historical Pattern Recognition and Backtesting Price Movements Are Important Tools To Forecast Prices

How can a person know that he needs to bring an umbrella during the month of September?

We know because we’ve had 20 occurrences for the past 20 years or a 100% hit ratio that it rains during the month of September at least 10 times in Manila, Philippines

I know this because I’ve never had a rainless birthday.  (September 10 is my birthday and it rains every time.  I only observed the weather when I was 7 years old because I had a birthday party and we had to be indoors else everyone will get wet.)  This is backtesting.  You simply evaluate what has happened in the past.  You don’t have to be a genius in the market to know that Seasonality Exists.

Concept 4:  Seasons affect the stock market and should be studied when trading because they help provide you an edge over others who are not actively monitoring price movements. 

Some studies have shown a strong seasonal tendency for Philippine stocks to rise in the six month period from October till March or November till April for the past 30 years.  Without having to go through the cliche and jargon that “Sell in May and Go Away” – essentially meant stocks drop in May or the monikers “Chinese Ghost Month  – Stocks Fall”, the observance has led to the urban legends.  Until these observations prove worthless, people will continue to trade their beliefs based on these occurrences because it is a pattern that provides an edge.  In fact, some traders use the Supermoon effect.  They opine that the phases of the moon have such a strong historical tendency to pinpoint the imbalance in trading emotions that most of the extremes in prices all around the world can be explained by the lunar tendencies of human behavior.  Just google them. The point is that if there is an observable phenomenon – people will use that edge to trade until the edge is gone.

Concept 5:  Throughout time, Charts Have Shown Repetitive Visual Representations of Market Emotions – and Can Thus be Reliably Traded Profitably Upon Knowing the Edges of Price Patterns. 

There are people who trade primarily looking at charts.  They call themselves technicians.  They believe that based on empirical evidence spanning hundreds, thousands or even millions of information – that their backtested data shows a positive expected value (a profitable trading system) when they buy a stock that is trading above major moving averages (50 day, 100 day) and if the price just crossed significantly above the 20 day moving average. This is an example of a trading system of a Moving Average Cross Over.

It’s kind of like a weather analyst saying that if the clouds are significantly hovering above the sky, and if the barometer crosses a certain atmospheric pressure, then we should expect rain coming within the next six or seven hours.  That’s all that this means.  People can use technical price indicators to confirm a bias, just as people use the barometer to measure the weather.  It’s the same.

the barometer.png

Many people can attest to using moving averages all their life and predict the price movement.  Trading the stock market is really almost about predicting the weather tomorrow.

We’ll give an example of a popular technical indicator (think of it as the scientific instrument – barometer.)

Below is a screenshot of the USDCHF 1 hour time frame chart.   The red, blue, yellow lines are the 14/20/100 day Exponential moving averages.  Below that is the ATR(20) or average true range of the past 20 hourly candles.

This is an ongoing trade.  I placed a SHORT USDCHF position at 0.9700 seeing a resistance in the daily chart and a downtrend channel, many years of backtested data shows me that USDCHF habitually declines when it cannot move past its channel.  I placed my stoploss at 0.9740 (a 40 pip cutloss to stop me out if I’m wrong – and a 0.25unit position shows that my risk is limited to $100.)

My target for this trade is initially 0.9590 or 110 pips with a time span for the entire week since the USDCHF has a Weekly ATR(20) of 200 pips. This means that we can expect USDCHF to move 200 pips in an upward or downward direction from high of the week to low of the week in that range.   If my words are beginning to sound like garbage, I’ll explain and define all these things in my next series of articles.   What’s important today is you know that we are trading based on a price pattern probability, we use indicators and backtest that trading system and then we make a bet based on that historical tendency.

usdchf trade example.png

  • I’ll tell you in my next article how the trade went 😀

Thanks!

– Faceless Trader (or BookAKA)

You can check these educational articles and more over at http://www.bookaka.com as well

We hope to invite all those who have difficulty understanding the stock markets to visit BookAKA.com and get to meet several traders contributing many free sentiments about their knowledge of the stock markets – and like weather analysts, practice predicting the price movement of specific goods (roses, tulips, stock prices) in the coming days. 😀

 

 

 

 

 

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