Читать книгу The Handbook of Technical Analysis + Test Bank - Lim Mark Andrew - Страница 16

Technical analysis is based on a few fundamental assumptions. The first assumption is that market action, which includes price action, reflects all known information in the markets. The market discounts everything except acts of God.

This means that the markets can only discount:

• Known information

• Expectations about known information

• Expectations about potential events

The market cannot discount:

• Unexpected events

• Unknown information

Market action is representative of the collective trading and investment decisions of all market participants, which directs the flow of supply and demand in the markets.

This implies that the technical analyst need only refer to the charting of market action, since all known information and expectation about such information has already been discounted by the markets. The actual cause or underlying reason driving demand or supply is irrelevant, as it is only the effect of such action that really matters, that is, prices rising or falling.

Some detractors of technical analysis contend that the assumption that all information is absorbed or discounted by the market is flawed. They argue that, with the exception of illegal insider trading, price cannot possibly discount an unexpectedly large block purchase of shares in the market before it occurs. The detractors are in fact perfectly correct in their contention, except for the fact that the markets do not actually discount unknown information or unexpected events. The market can only react to what is known or expected, which includes insider activity. It does not react to what is unknown or unexpected. Although insider information is nonpublic, it is still considered to be known information, since the action of insider buying and selling impacts market action and as such represents information in the markets.

It may be more realistic to think of the market as in a continuous process of assimilating and adjusting to new market information, rather than an unrealistic full-blown discounting of all information instantaneously.

What Are the Markets Really Discounting?

It is not merely news, economic releases, or corporate data that the markets are discounting. The assumption is that it discounts everything. This includes:

• Information about actual events

• Expectation about actual events

• Information about expected events

• Expectation about expected events

• Expectation about the possibility of unexpected events

Some also argue that there are many other forms of discounting like buying the rumor and selling on the fact. They are curious as to what the expectation should be in such a case. Should the expectation be that prices will appreciate once the good news is released or should the expectation be that prices will fall once the good news is public knowledge (since everyone is in fact selling on good news)? How would we know if the market is discounting the:

• Rumor itself

• Expectations about the rumor

• Expected good or bad news

• Actual news

In reality, the market discounts all of the above. Regardless of what the markets are discounting, be it quantifiable or otherwise, the end result is that price and markets action will ultimately reflect the collective expectation of all participants.

Market Discounting versus EMH

Efficient Market Hypothesis (EMH) states that for a market to efficiently discount and reflect all information perfectly, all of its participants must act on all information in the same rational manner instantaneously. Does this definition of EMH also apply the basic assumption in technical analysis that the market discounts everything?

Detractors of EMH contend that the act of discounting everything is not realistic or is largely impossible. They argue that the problem lies in the action taken by the participants. Not all participants will react to the same event or information in the same way, and in fact, some participants may act on it in a contrary fashion, that is, shorting the market rather than going long. They also argue that not all of the participants will react at the same time. Some will take preemptive action or act in anticipation of the event while other participants will act during the actual receipt of the information. There will also be participants who may react long after the information is released. Hence, trying to achieve a certain level of coordinated action for efficient discounting will be virtually impossible.

The detractors of EMH also contend that for the markets to discount all information effectively, all participants must have access to that information and must act on it. The market will otherwise be unable to discount or reflect all information effectively. This requirement itself presents a difficult challenge. They argue that it is virtually impossible to get all of its participants to act on all of the information. It is also unrealistic to expect all participants to have access to that information, and even if they do, we cannot expect the participants to be standing by at all times in readiness to act on such information. They further argue that information is never free. It is unrealistic to expect that all participants are able to afford the information, let alone all information.

There is a very subtle difference between efficient discounting in EMH and basic market discounting in technical analysis. As far as market discounting in technical analysis is concerned, there is no requirement of perfect efficiency except for the requirement that it discounts everything that becomes known to it, which includes the sum total of all actions taken by its participants, be it in a timely or untimely, rational or irrational fashion. Market action itself represents the ultimate truth and is a direct consequence of the market discounting all information known to it, regardless of whether the information is perfectly efficient or otherwise. The market continues to discount all information and expectations of such information as and when it unfolds and becomes known to the market. The term efficiency therefore, as far it applies to the basic assumption in technical analysis, refers to very act of discounting all information as it becomes known to the market, regardless of the type, quality, or speed at which it receives the information. For the technical analyst, price is (always) king and represents the ultimate truth in the market. The markets are never wrong. All market action is considered perfect and efficient under the basic premises of technical analysis. Hence, we see that the term efficient does not carry the same meaning or implications as in the case of EMH. In EMH, efficient has a very specific meaning.

The premises upon which EMH are constructed require that all new information be discounted immediately and rationally in order for the market to be perfectly efficient. Efficient under EMH means that the market participants must react:

1. Instantaneously to all market information

2. Rationally to all market information

EMH requires new information in order for prices to change. Bullish news will cause prices to rise and bearish news will drive prices down. Acting rationally means that all participants will make the same logical decision based on the new information received. Instantaneously means acting or responding immediately to new information. Therefore, for the market to efficiently discount or reflect all information, all of its participants must act on all of the information in the same manner instantaneously. See Figure 1.27.

Figure 1.27 Efficient Market Adjusting to New Information.

EMH contends that since the markets are efficient, there is no point in employing technical analysis, as prices would have already adjusted to the new information and the analyst would have no way of forecasting future action without such information. The reality is that there is discounting in the markets, but it is in no way perfectly efficient. In other words, the markets are at best semi efficient. This is because it is impossible to have all market participants acting instantaneously and rationally. It is a physical and logistical impossibility in the physical world. A simple “handclap” test will prove the point. If a large group of participants was asked to clap in response to a specific single event like the ring of a bell, we would find that there is little chance of observing a perfectly coordinated handclap across the group once such an event occurred.

As we have already discussed earlier, not all participants in the real world would react in exactly the same manner or arrive at the same logical decision based on the new information. Some market participants may have a different view of the markets and view the new information as inconsequential with minor impact on the markets, and may even trade against the new information. Also, there are a large number of strategies that one can employ to trade the markets based on the same information. As a result, when new bullish information is released, participants may:

• Enter a long position immediately

• Enter a short position based on an average-up scale-trading strategy

• Scale in more positions as the market rises

• Scale out positions that may have already been in profit

• Wait for prices to become overextended before fading the breakout

Even if the market participants were to act rationally and all make the same logical decisions based on the new information, they may not be able to act on the information instantaneously. They may have received delayed information or were not standing by in readiness to act on the information when it arrived. They may also find it physically impossible to act on all information, especially when information streams in continuously in very quick succession. They may also be unable to afford the cost of such information. As such, the discounting of new information will take place at a slower rate, with a semi-efficient market adjusting gradually to the new information as market participants compete with each other for the best fills. See Figure 1.28.

Figure 1.28 A Semi-Efficient Market Gradually Adjusting to New Information.

Figure 1.29 is a 5-min chart of the EURUSD depicting the markets adjusting to new information, in this case the nonfarm payroll and unemployment report. Notice how prices swing back and forth as traders compete with each other in light of the new information. Price finally makes a top at the 61.8 percent Fibonacci projection (projecting AB from Point C) level and begins consolidating.

Figure 1.29 A Semi-Efficient Market Gradually Adjusting to New Information.

Source: MetaTrader 4

Nevertheless, EMH assumes three basic levels of information discounting:

1. The Weak Form: The weak form of EMH suggests that all current prices have already been fully discounted and, as such, reflect all past price information. Therefore, they cannot impact future prices. The application of technical analysis is therefore pointless and meaningless.

2. The Semi-Strong Form: The semi-strong form of EMH suggests that all information, once public, is of little use as price would have already adjusted to the new information making the use of such information unprofitable and pointless. Market participants would have little opportunity to take advantage of such information. This implies that even fundamental analysis is pointless and meaningless.

3. The Strong Form: The strong form of EMH suggests that all information, regardless of whether public or private, would have been already fully reflected in the current price. Consequently, all forms of analysis and forecasting are pointless and meaningless.

Random Walk

Closely related to the EMH is the concept of Random Walk. Random walk suggests that prices move in a purely random manner and that:

• Past prices do not have any influence on current price

• Current price has no influence on future price (Markovian condition)

All information is already incorporated into the current price. This would mean that there is no way whatsoever to forecast future action, and prices are as likely to go up as they are to go down. This renders all form of analysis and forecasting pointless and meaningless. Random walk is in a way related to EMH, insofar as current price represents the current state of all information. In random walk, prices do not adjust to any new information, unlike in EMH. Its motion is purely random or stochastic.

So, are the markets following a random walk? As we already know, the markets are driven by perception and expectation and not by random acts of buying and selling. It is totally inconceivable that all participants invest in the markets in a purely random fashion, completely unencumbered by cost, emotions, psychology, and biases. As we already know, market participants tend to react in a highly predictable manner time and time again. It is the author’s opinion that random walk is simply not a true representation of everyday market action. See Figure 1.30.

Figure 1.30 Random Walk, EMH, and Their Implications.

Real-World Discounting

In the real world, markets overreact and there is insider activity. With insiders buying and selling, prices adjust to reflect this information. See Figure 1.31. Once the new bullish or bearish information is released, the insiders would in fact be liquidating positions in profit, selling off the shares to the public.

Figure 1.31 Insider Activity Impacting Market Action.

Figure 1.32 shows the market overreacting to new information. We see the insiders accumulating shares prior to the release of the new information. The public joins in after the information is published. Public participation begins to increase as more participants join in the now obvious rally in prices. This contributes to the herding behavior that finally causes the market to overreact to the new information. This is exactly what the insiders are hoping for, in order to extract the greatest amount of profit. Eventually a top is formed as the market runs out of buyers and/or money to invest. The activity subsides only to repeat again.

Figure 1.32 Markets Overreacting to New Information.

Price versus Value

One interesting question that many novices ask is whether the market is discounting price or value. In fact, a more fundamental question to ask would be whether price represents value. If it does, then how do we explain a stock valued at $10 rising to a price of $30 in the absence of any significant changes in its fundamentals?

In reality, market action is merely the collective expectations of all its participants. What we are really trading is expectation. It has not very much to do with absolute intrinsic value, but rather its expected value. In short, current price is the result of expectations about future price and value.

Market Behavior Repeats Itself

The second assumption or premise of technical analysis is that market behavior has a tendency to repeat itself. This means that past price and chart patterns will provide a reasonable basis for forecasting potential future behavior. The underlying explanation for the repeatability of price and market behavior lies in the fact that market behavior is driven by human psychology, which seldom changes over time. The uses of past patterns to predict futures moves are grounded in the reliability and consistency of human behavior.

Ironically, most equity valuation modeling and standard economic statistical indicators are based on past or historical information as well. How else are we able to make an intelligent assessment of future outcome without reference to past data? It is human nature to try to infer, extrapolate, generalize, and predict potentially probable future outcomes.

The reason for the popularity of classical price and chart patterns lies in the fact that they are essentially visual in nature. Human beings have an innate tendency for pattern recognition and as such there is a natural inclination to gravitate toward such forms of analysis. The reliability of pattern analysis tends to improve as more market participants start to employ such patterns in their day-to-day trading and forecasting.

Unfortunately, there are some challenges to the reliability of using past action as a forecasting tool, some of which are:

1. The preempting effect will slowly erode the reliability of historical patterns as traders start to outbid or outsell each other in anticipation of the approaching technical trigger levels. Preempting is a direct result of the self-fulfilling prophecy.

2. The effect of widespread program trading will affect the reliability of historical pattern trading as programs are able to trade in ways not easily replicated by manual or human trading.

3. The ever-changing influx of new participants into the markets will slowly affect the reliability of chart and price patterns unfolding in the expected manner. Although human psychology remains largely predictable over the longer-term horizon, short-term patterns are sometimes impacted by new participants who have a slightly different approach than the usual participants in that market.

The Market Tends to Move in Trends

Lastly, from the definitions given of technical analysis, it is generally accepted that the market has a tendency to move in trends. This explains the popularity of trend-based methodologies. Of course, it is not hard to understand the basis for the popularity of trend trading, since trend action affords market participants the greatest profit over the shortest possible duration in the markets.

But if we analyze this statement more closely, we understand that the term trend is inconclusive. What is actually is a trend? When is a trend a trend and when does it cease to be one? There have been many attempts to define what a trend is objectively. Successively higher or lower peaks and troughs is one widely accepted method, and is by far the preferred mode of identifying a trend. But then this begs the next question, which is: what constitutes a peak or a trough? Significant containment of price below or above a trendline or sloping moving average may also be deemed a valid way of defining a trend. We shall delve into the specifics of defining trends, consolidations, and other formations in Chapter 5.

Although trend following is popular, there are some challenges to using it, some of which are:

• Inefficient trade sizing in volatile markets

• Inefficient profit capture during trends

• Inefficient performance in ranging markets

• Inefficient adaptation to more volatile trend action

• Inability to identify trend changes efficiently

• Possibility of negative slippage in fast-moving markets

• Possibility of large drawdowns due to the low winning percentages

• Reduced performance caused by whipsaw action during consolidations

• Influx of trend-capturing systems produces inefficient fills

• Ineffective back and forward testing

Finally, it is important to note that a trend in one timeframe may be a sideways market in another.