Wednesday, December 14, 2011

The Chart Mirage

In a recent essay I ripped away all the technical tools that decorate my charts, declaring them to be useless for practical trading and leaving myself pitifully clutching a bare price and volume chart.

Now, I’m going to double down with an even more radical statement.

What you see on that bare chart is an illusion.

At this point it is natural for any trader reading this essay to scratch her head sadly and say, “Well, old traders never die. They just fade away, and grow increasingly crazy the dimmer they get.”

But hear me out. I may in fact be crazy -- I don’t reject that theory out of hand -- but it may be that I’ve hit upon a truth that will help me be a better trader. If crazy has that result, then three cheers for crazy!

Lying behind any stock chart is an order book, such as Level II display for NASDAQ stocks.

Compared to the complexity of a one-year daily chart, Level II is simplicity itself. It shows bid prices, ask prices and the number of shares offered or sought for each.

Those elements -- a price and a quantity of goods -- are what constitutes a market.

That fact illustrates the harsh reality that confronts every trader: We have no control over or knowledge of the future or the past. The only thing we can control is our order, consisting of a quantity and a price.

A trade becomes history the moment it is made. When the chart says NFLX is trading at  $130.56, it means that the stock last traded at that price. It isn’t necessarily what’s on the Level II board now, and so has no current reality.

So that pretty one-year daily chart with the red and green candlesticks and mountain range of volume is a record of history, a mere mirage masquerading as an illusory “trend” that will push on into the future.

If that’s the case, then why should a trader spend even a moment looking at charts?

There is a school of thought -- classic tape-reading -- that says charts should have no role in trading. Rather, the trader makes decisions by looking at trades as they pass on the screen -- the modern equivalent of the old ticker tape -- and the current set of orders in order to judge market sentiment.

But I think that the charts -- the history -- do have an influence on the future prices.

We human beings are time-binders -- we link the past to the present and future through our normal ways of thinking and understanding the world. That’s how we learn from experience.

We create patterns out of chaos and base our actions on those patterns.

Moreover, all traders are human and have this human propensity. Even the robot traders that caused the <a href=>Flash Crash</a> in 2010 contain human assumptions.

So the record of prices may lack present reality, may be a mirage, but each time a trader looks at that record, scratches his head, and makes a decision, it influences the future course of the market.

The influence is there, but filtered through the minds of traders.

Having tossed my grab-bag of technical tools into the garbage, I must learn how to use the bare chart and the tape as my primary trading tools, and to figure out the limits of what I can do.

What must I look for to determine  if a chart is bullish, bearish or insipidly neutral? Am I allowed to draw trend lines, as a visual aid?  What about Fibonacci retracement levels?

Each time I draw on the chart, it is an abstraction that takes me a step away from the underlying reality of the markets.

Learning these skills is a daunting task, because it scratches a much deeper issue: How does a trader make decisions? What is happening in the trader’s brain, and how can that activity be harnessed to produce profits? That will be the subject of a later discussion.

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