Chapter 8. The Basics Are Not Enough
A foundational trading strategy consists of both the understanding of pattern recognition and the ability to exploit these patterns for profit. It is my goal that by the end of this book you will possess both. Although these two items are essential, these basic understandings are not enough, and so it is also my goal for you to learn when to alter this basic understanding to profit not only from the moves in the stocks but also from the moves of others. As you start down the trading road, you will quickly see that if you were to pursue just the basics, many times you would be a sitting duck, opening yourself up to losses from those who have already moved on to the next level of trading the trader.
For hundreds of years, people have studied crowd mentality when it comes to the markets. These studies usually always come back to focus on fear and greed, especially during times of great volatility. The masses are always assumed to be moving blindly about, with the common thread being their emotional attachment to the broad market movements, over which they have little or no control. Strategies have been developed to capitalize on these mass movements, yet I believe we’re seeing a fundamental shift that mandates our trading must adapt to these changes, too. From my vantage point, the masses are no longer being led blindly about but are educating themselves to pursue at least some trading plan that gives them a better understanding of the market and its movement. If my assumption is correct, the basics that most people are gravitating toward may no longer produce the desired results. Considering that these basics were initially developed to exploit the masses, if these same people are now pursuing these strategies, how can they possibly provide the same edge?
At its core, technical analysis seeks to quantify and predict the movements of other traders, giving the applier of the technical analysis an edge. It is assumed that when you study technical analysis you are studying patterns being developed primarily by those not studying the same thing. Although this might have been true a few years ago, today the landscape has shifted dramatically. Instead of pursuing technical analysis with the assumption that the masses are not, I believe we must pursue technical analysis with the assumption that the masses are studying the same. It is only with this thought that we can look objectively and realize that at times, to be successful, we must trade the trader who is simply trading the basics.
For quite some time, technical traders had a strong edge just playing the basics. It was similar to two chess players competing but only one knew the rules or was well versed in the game. The match was no match at all because the player who had no real understanding moved blindly about losing game after game. Sure, that person might have gotten lucky a time or two, but over the long run the person lost consistently. Finally, the player without any real understanding got sick of losing and began to educate himself more about the game and basic strategy. Assuming now that both chess players have the same knowledge of the game, as well as the same understanding of basic strategy, who will win? The winner is usually the player who can think ahead of the other player. In chess, this can be several moves ahead. At some point, it will come to that in trading, too. However, for the time being, you need to ponder only what the next move will be and make your decisions accordingly.
Let me explain further.
Odds are, you are already familiar with some common technical analysis terms, such as support and resistance. Furthermore, you are probably already aware of technical patterns, such as the previously mentioned cup and handle and the head and shoulders. If you are not aware of any of this, while you may believe you are with the masses, you are actually behind the masses and need to catch up quickly. Let us assume for a moment that you understand basic technical analysis enough to decipher patterns as they develop on charts for key stocks or markets. Let’s also assume that a pattern begins to develop that can be plainly seen and leads you to position accordingly for what should be the market’s or a stock’s typical outcome. Years ago, you might have been part of a small group taking the action you did. Rather than be subject to the random ups and downs of the market, you would take your cue from the action itself. Once a pattern developed that you recognized, you would move in accordingly seeking a desired result. Now, you find that rarely do the patterns you have learned work as expected. Rather than be one of the few, you are now one of the many, and thus significantly decreasing the probability the pattern works in your favor. If the landscape has shifted and now the vast majority of traders are positioning for the same outcome that should transpire, doesn’t it make sense that the odds of this transpiring has been dramatically reduced?
As previously discussed in Chapter 4, “The Other Traders,” this was clearly obvious during the summer of 2009 when the S&P 500 had established a head and shoulders topping pattern that received more attention than I have ever before seen a technical pattern receive. The consensus was that the market had topped out and was preparing to roll over. This was confirmed by a head and shoulders pattern so widely accepted that the pattern itself was doomed to fail. Figures 8.1 and 8.2 display this pattern and its outcome over the next several days.
After this now famous head and shoulders pattern failed, technical analysis received extremely negative press when pundits relayed to us all just how wrong the pattern in question resolved itself. I viewed the outcome as something quite different and was convinced more than ever that technical analysis had power beyond even my wildest expectations, as long as I embraced the next step of understanding.
Figure 8.1 S&P 500 after forming a head and shoulders pattern in July 2009.
Chart courtesy of Worden—www.Worden.com.
Figure 8.2 The S&P 500 rallied significantly once the head and shoulders pattern failed to break lower.
Chart courtesy of Worden—www.Worden.com.
The problem for most investors is that their belief about what technical analysis is ends with the basics when it should, in fact, just begin there. If at its core technical analysis is the graphical representation of traders’ emotions and now most of those traders are seeking to capitalize by using basic technical analysis, your goal is no longer to assume the basics will always work. Instead, you must sometimes be able to alter your strategy to trade the traders who are trading the basics.
It is important that this idea soaks in. I cannot stress enough how incredible the possibilities are for profit once you understand trading the trader as an edge within itself. Simply imagine if instead of waiting for the head and shoulders pattern noted in Figures 8.1 and 8.2 to resolve itself downward, you immediately went long on its failure.
In the past, large financial institutions or mutual funds often provided the technical analysis footprints you could follow to gain a general perspective for where the market or a stock was moving in the future. These funds didn’t usually bother to cover their tracks; instead, they moved like an elephant through the woods, plowing over whatever stood in their path, leaving a trail for most to follow. Over the years as competition in the institutional world has grown, it behooves mutual funds to be as strategic as possible as they attempt to outperform their peers. One of the ways in which they have done this is by no longer being so brazen with their purchases or sales. Mutual funds now understand the growing world of technical analysis and have the ability to significantly improve their results by using their size to influence the patterns traders are playing. As the mutual fund world has become increasingly more competitive, in addition to other products such as ETFs (exchange traded funds) or retail brokerage firms competing over this money, these financial institutions have been forced to alter their strategies a great deal.
To assume these funds and their traders don’t know what the average Joe is doing, seeing, or feeling is an ignorant mistake. Traders at these mutual funds now prey on the basics of technical analysis to execute a better price point regardless of whether they are buying or selling. Have you ever been stopped out of a stock at a predefined level only to see it roar back with a vengeance after stopping you out? Did you feel like a sitting duck or that someone might have known exactly where your stop was? Well, would you be upset to know that probably both were true?
Suppose, for example, that a mutual fund has its eye on stock XYZ and wants to own several hundred thousand shares. In the past, these funds might have just start buying shares day in and day out without regard to any hint of secrecy. The rapid rise in price accompanied by a significant increase in volume would make it apparent the stock was under institutional accumulation. Because of the increased competition today, traders at these firms are now well versed in technical analysis and pattern recognition, and they understand that most retail traders are now using these strategies for their edge. These institutional traders also have the money and power to create or break their own patterns. Odds are that on the rapid price decline, where you were stopped out only to see the stock reverse course immediately, an institution sold a significant number of shares at a key level where they knew basic stops would be placed. Once this level was breached and the stock fell swiftly, due to the large number of stop orders in place, they were able to reverse their position and buy those shares at a lower price and thus lower their total cost basis in the stock a great deal as they bought into the drop. Is that wrong or illegal? Not at all, it’s just the reality that most institutions have already accepted that the landscape has changed and to compete they must also change.
Understanding a basic pattern recognition strategy is a must and lays a foundation you can build on. However, once you gain this understanding, you must quickly thereafter start to think one step ahead. Throughout this book, I first lay the foundation for a sound trading strategy with pattern recognition at its core. I then conclude with a discussion about how to evolve this strategy from the basic to the advanced. It is extremely important that you first master the basics. Only then can you start to trade the trader.