Technical Analysis of Trends: Cracking the code

Technical Analysis of Trends: The Trend Is Your Friend

Updated April 30, 2024

Regarding analysis, stock trends via both Technical & Fundamental Analysis fall short. Individuals have been led to believe that to succeed in the markets, they should embrace mechanical systems (Technical analysis) or fundamental analysis. No matter how hard you look, you will not find an answer if the premise is wrong. (Mainstream) Technical analysis is based on a fixed set of rules and, in that sense, does not differ much from Fundamental analysis.

Fundamental data is provided in a standard format, so anyone accessing that data will arrive at the same conclusion. The same applies to technical analysis based on a fixed set of rules. The only way to win is to see things that most people will not see, so anything standardised will not work. The mass mindset wants to feel safe and deems safety in numbers, but there is only danger in the markets.

Stock Trends and Mass Psychology

The following excerpts from past Market Update issues, part of our premium service, vividly illustrate the principles of Mass Psychology in action.

Now, everyone is expecting a solid move, and they might get a minor pullback. Market update May 7, 2019

Even if the Dow were to trade to the 24,500 range or slightly below that level, the move would be slight compared to the correction the Dow experienced towards the end of last year. And it would appear insignificant if one goes back to 2015. For the record, this market will crash one day, though the word crash is over-abused if one takes the forest perspective. In the long run, there is no such thing as a crash; that word should be replaced with opportunity. One needs a multi-timeline approach; in layman’s terms, it means looking at the market from multiple timelines. Market Update May 20, 2019

Understating the markets, therefore, comes down to one factor: “emotion”. Market Update May 12, 2019

Trading Language: Idiocy in Action

The language used in trading is nothing short of absurd. Bullish and bearish are among the most ludicrous terms employed in financial circles. These animalistic monikers convey little meaning and fail to capture the complexity of human emotions and behaviours. Instead, they reduce investors to mere creatures devoid of intellect or reason.

Moreover, the trading community has developed several jargon and acronyms, ranging from scalping and plunging to upthrusts and climactic sell-offs. Such terminology serves to obfuscate rather than clarify, creating confusion and miscommunication. Furthermore, such language fosters a sense of exclusivity, alienating those unfamiliar with the lingo and reinforcing the notion that trading is a mysterious and elusive pursuit.

The Masses Act Like Lemmings

The masses in trading behave like lemmings, following the herd blindly. They succumb to fads and trends, buying into popular sectors and selling off losing positions prematurely. They allow fear and panic to cloud their judgement, leading them to exit profitable positions too soon. Conversely, they become overly confident during bullish euphoria, failing to acknowledge the risks associated with excessive optimism.

This herd mentality leads to excessive volatility and exaggerated price swings, exacerbating losses and limiting profits. Those who dare to buck the trend face ridicule and scorn, ostracized from the group for their nonconformist views. The result is a stagnant and insular community, resistant to change and innovation.

Mastering Technical Analysis: Navigating the Pitfalls of Mechanical Trading Systems

Investors often turn to mechanical trading systems, believing they offer a foolproof solution to navigating the volatile world of stocks. However, these systems are fundamentally flawed, as they fail to consider the crucial role played by human emotions in shaping market movements. To truly excel at technical analysis, one must understand the dynamics of crowd behaviour and adapt strategies accordingly.

Mechanical trading systems are designed around predetermined rules and algorithms to minimize risk and maximize returns. While they appear straightforward and logical, such systems overlook critical factors. They assume that historical data accurately reflects future market conditions and that humans behave rationally and consistently, ignoring emotions’ significant role in decision-making.

Richard D. Wyckoff (Livermore), a pioneer of modern technical analysis, warned against overconfidence in mechanical trading systems. He believed that while these systems could help provide guidelines, success in trading ultimately required intuition, judgment, and flexibility. Livermore urged traders to observe market behaviour, paying close attention to patterns, trends, and fluctuations rather than adhering rigidly to arbitrary rules.

Similarly, Niccolò Machiavelli emphasized the importance of adaptability and pragmatism in achieving desired outcomes. In trading, it is imperative to remain agile and flexible, capable of adjusting strategies and tactics according to changing circumstances.

Warren Buffett captures the essence of successful investing with his famous quote, “Be fearful when others are greedy, and greedy when others are fearful.” This highlights the importance of going against the grain and maintaining a disciplined approach. The masses often seek easy answers and quick fixes, reflected in their preference for mechanical systems and get-rich-quick schemes. However, as Buffett noted, “Someone’s sitting in the shade today because someone planted a tree a long time ago.” Success in investing requires patience, discipline, and a willingness to put in the work.

History provides valuable lessons, yet the masses often ignore them, repeating the same mistakes. Buffett wisely stated, “You only have to do very few things right in your life so long as you don’t do too many things wrong.” This underscores the importance of learning from mistakes and avoiding the pitfalls that have ensnared others.

Each person will have a unique perspective on technical analysis. Identifying the indicators that resonate with you and dedicating yourself to mastering them is essential. As Buffett said, “Risk comes from not knowing what you’re doing.” Thus, knowledge and understanding are your greatest weapons in the investing arena.

The key to mastering technical analysis is understanding your most significant obstacle – your emotions. Once you recognize this, you can focus on deciphering the behaviour of the markets and other investors. Remember that technical analysis tools are just that – tools. They are not rigid rules to be followed blindly. Adapt these tools to your understanding and look for patterns that resonate with you.

Understanding Crowd Behavior

At its core, technical analysis involves analyzing crowd behaviour and attempting to discern underlying sentiments and trends. Markets are composed of countless individual actors, each driven by their unique motivations and beliefs. Understanding these drivers is fundamental to developing effective trading strategies.

Crowds exhibit various behaviours that savvy investors can exploit. For instance, during periods of exuberance, prices tend to rise rapidly, fueled by optimistic expectations. Conversely, prices decline precipitously during pessimism as investors abandon their holdings en masse. By observing these patterns, traders can anticipate potential market moves, allowing them to capitalize on favourable opportunities.

However, it is equally important to understand the limits of technical analysis. While charts and graphs can provide valuable insights, they cannot fully capture the complexities of human behaviour. Traders must exercise caution and maintain a healthy scepticism regarding the reliability of these tools, continually refining their methods as new information emerges.

Embracing Human Emotion

Ultimately, markets are shaped by human emotions, including greed, fear, and uncertainty. Effective traders must embrace these emotions, recognize how they influence market behaviour, and leverage them to their advantage. As Livermore observed, “Most people who enter the stock market think they can beat the averages without special training or education…They soon find out the harsh fact that stock market riding is hell on the unsophisticated.”

To succeed in trading, it is essential to develop a deep understanding of market dynamics and adopt a disciplined, systematic approach. Traders must cultivate a rigorous analytical framework incorporating quantitative and qualitative factors and remain open to continuous learning and adaptation. Moreover, they must possess vital emotional intelligence, capable of managing stress and uncertainty effectively.

Technical Analysis: A Powerful Tool for Trading Success

Technical analysis is a critical skill for traders aiming to improve their results. Customizing the settings of your analysis tools is essential to gaining an edge in the markets. Standardized settings are used by the masses, and following the crowd rarely leads to exceptional outcomes. As Machiavelli astutely observed, “The first method for estimating the intelligence of a ruler is to look at the men he has around him.” Applying this to trading, seek out unique perspectives and tailor your tools to fit your strategy.

One effective method for analyzing stock trends is trend analysis, a simple yet powerful technique. Drawing on the insights of legendary trader Jesse Livermore, who made and lost several fortunes, trend analysis involves identifying emerging trends and riding them to profitability. Livermore’s approach centred on price patterns, volume analysis, and a keen understanding of market psychology.

Critical Principles for Mastering Technical Analysis

Emotions Drive the Markets: Livermore recognized that markets are driven by fear and greed. Identify the prevailing emotion and position yourself accordingly. Machiavelli’s advice to “never waste the opportunities offered by men’s emotions” is apt here.

Contrarian Investing vs. Mass Psychology: Understand the difference. Contrarians take positions against the masses, while mass psychology focuses on the intensity of emotions. Machiavelli’s principle of “appealing to the people’s passions” applies as you aim to identify euphoria or panic to time your trades.

Patience and Discipline: Livermore embodied these virtues. He often waited for the right moment to enter a trade, even if it meant missing out on immediate gains. Machiavelli’s counsel to “never make a change except for some new and obvious necessity” resonates here.

Portfolio Management. Diversification is crucial. Livermore’s losses, at times, stemmed from concentrating his positions in a few stocks. Machiavelli’s wisdom on “dividing resources to maintain power” translates to spreading risk across various investments.

Practical Application of Technical Analysis

Livermore’s methods, combined with mass psychology, offer a robust framework:

Identify Trends: Use trend analysis to spot new directions and stay with them until they end.

Understand Market Sentiment: Gauge the intensity of emotions driving the market. Fear and greed are potent indicators.

Practice Risk Management: Diversify your portfolio and use stop-loss orders to limit potential losses, as Livermore did after significant setbacks.

Adapt to Changing Conditions: Livermore traded based on the market’s current state, not his expectations. Machiavelli’s advice to “adapt your plans to the circumstances” is relevant here.

Conclusion: Analysis of Trends

Mastering technical analysis demands a nuanced, multifaceted approach, combining elements of rational analysis with an appreciation for the role of human emotion. Traders must resist the temptation to rely exclusively on mechanical trading systems, instead embracing a holistic view that integrates technical, fundamental, and psychological perspectives. By remaining vigilant, adaptable, and committed to ongoing learning and development, traders can achieve sustained success in the dynamic and ever-evolving world of finance.

In conclusion, while mechanical trading systems may seem appealing, they often fail to account for the complexities of human emotion and market dynamics. To succeed in technical analysis, one must develop a nuanced understanding of crowd behaviour, remain adaptable and pragmatic, and learn from the wisdom of successful investors like Wyckoff, Machiavelli, and Buffett. By dedicating oneself to mastering the art of technical analysis and avoiding the pitfalls of blind adherence to rigid systems, investors can navigate the volatile world of stocks with incredible skill and confidence.