This is probably going to turn into a sprawling essay, but I’ll try to keep it as cohesive as possible. I want to summarize some things I’ve been talking about in more chatty arenas lately. Maybe it will make more sense, here in one place.
My basic message is: people throw around a lot of fancy ideas about trading. Forget all the fancy ideas, for a few minutes. Get back to basics. They’re not as basic as you might think!
Only Two Truths in Stocks
There are only two things you can absolutely believe in, when it comes to a stock. Those are the price, and the volume. Nearly everything else you look at–every indicator you use–is just some distorted version of those two facts.
Think about what an indicator is. An indicator takes millions of price and volume scenarios and maps them onto a relatively small range of numbers (in algebra, we call that a surjection). This is, at its core, an operaton where you will lose information. For example, take these three sets of closing prices:
| Date | 5/7 | 5/8 | 5/9 | 5/10 | 5/11 |
|---|---|---|---|---|---|
| Stock 1 | 1 | 2 | 3 | 4 | 5 |
| Stock 2 | 5 | 4 | 3 | 2 | 1 |
| Stock 3 | 2 | 5 | 1 | 4 | 3 |
These stocks are obviously acting very differently, yet in each case their 5-day SMA is 3. And, that’s not even considering their range for the day… just the closing values.
So, indicators emphasize some qualities about a stock, by hiding other quialities. This is simultaneously why indicators are useful, and also why you should fear them. The question you should always ask is: “does this indicator emphasize what I want to find, and/or hide what I don’t care about?” If not, why are you looking at it?
In one of the excellent Market Wizards books (sorry, can’t remember which one, but you should read them all anyway), Schwager makes a hypothesis about how traders can look at completely different charting setups and still be successful. He suggests that, because all indicators are just transformations of the price and volume, it’s really just a matter of what you are used to, and which patterns you’ve learned to spot. The same situation will create one set of patterns in one indicator setup, and another set of patterns in a different setup. As long as both traders know how to spot their own profitable patterns, the choice of indicators really doesn’t matter.
Even your candlestick and bar charts are just indicators! I think I read this first in Trade Your Way to Financial Freedom, and it really opened my eyes. A 15-minute candlestick chart summarizes the stock movement and volume in terms of the price range in 15-minute slices. In doing so, it hides a lot of information about what happened inside of that timespan. Did the price spend the majority of that 15 minutes near the top of the range? Did most of the volume come in at the open of the candle? You don’t know. An extremely clear 11-minute cycle will be completely hidden in your 15-minute chart. Heck, a 15-minute cycle will potentially be obscured by your 15-minute chart, if the chart and the pattern aren’t in phase!
The Hunt for Better Charts
I had the mindset I outlined above this week as I took a look at various types of charts. I’ve been asking myself, what do I want my charts to point out to me? It’s been obvious to me for some time that I don’t care for time-slice charts. If you were looking over my shoulder, you could tell by the way I was constantly switching timeframes, trying to figure out what was happening. I don’t think it matters what the price did over the last arbitrary timeslice. That’s not a piece of information I can use to trade effectively. Or, at least, I was hoping there were better options.
[EDIT: I want to add that I'm primarily talking about intraday charts here. Daily candlesticks still make plenty of sense to me, because a trading day has a definite beginning and ending. As such, the open and close of the candles has a meaning, to me.]
I started to investigate Tick and Volume charts.
Tick Charts… No, Thanks!
Tick charts often show clearer patterns than time-slice charts. But, they are not for me. They do not highlight what I am looking for, and in fact actually distort the information I am trying to come across! My objections to tick charts are essentially:
- You want to equate Ticks to trades, and you can’t. How many times do I issue an order for 3000 shares and get filled for them all in one print? It happens, but especially on the Nasdaq stocks I’m not surprised at all if I’m filled in 30 100-share increments. That’s 30 prints on your tick chart. So, you might see a surge on a Tick chart and think “trading is really picking up,” when in fact it’s just trades getting filled in smaller fragments.
- Trade rate (or, taking into account the distortion I just pointed out, print-rate) is an important, but localized effect. I love to see prints going by faster than I can read them, at the point when I get in a trade. Why? Because it means no one has any time to think. It makes people nervous, and makes them make mistakes (like buying my shares from me at the top of a profitable run). But, do I care about the speed of trading two hours ago? No, I don’t… it’s got no effect anymore. Then, why would I want the shape of my chart two hours ago to be based on the trade rate back then? I wouldn’t.
Volume Charts… Thanks?
I much prefer volume charts to tick charts. They are a very simple combination of price and volume, and I find the features they highlight to be useful for trading decisions. For instance, they clearly show if a move is on (relatively) high or low volume. Such as, a tall candle is likely to reverse, because there was no volume behind it. They clearly show when volume was concentrated in a certain range. They take hours of afternoon chop that you shouldn’t be trading, and compress it into a single candle in a lot of cases. Safely out of the way!
Volume is very important, and (unlike trade rate) has lasting effects on the trading atmosphere. I think of volume like trade propellant… the more there is during a breakout, the more fuel the breakout will continue to have. Here’s the basic reason why: let’s say I get long a stock at 10, and it runs to 10.50. I’m happy, because I’m in the green, but what about the trader I bought my shares from? There are four major cases I can think of.
- The other trader had sold too early, and is now unhappy about the missed opportunity for profit. They walk away. No effect on the stock.
- The other trader had sold too early, and re-establishes a long position. That’s buying pressure which helps the stock go even higher.
- The other trader had sold me the stock short, and is now feeling pressure to cover. That’s buying pressure, pushing the stock higher.
- The other trader had sold me the stock short, but they have the guts to stay short. Still, they might want to end the pain if the stock gets back to break-even or a small profit. This would be buying pressure helping my long trade stay in the green, right where I need it most!
That’s oversimplifying, but it’s fine for a thought experiment, I think. So, in three out of four cases, the trader on the other side of my trade actively helps make my position more profitable. Admittedly, we have no idea what percentage of the time those three cases are in effect, but it doesn’t really matter, since that first case has no effect on the stock. In other words, the more shares are exchanged at a given level, the higher the chance that a significant additional push in the same direction will occur after a breakout.
It works if I’m short, too, and in fact this is also part of the reason that breakouts up are typically slower than breakouts down. Haven’t you noticed that stocks can usually fall straight down, but have to grind their way up? Part of it is the fact that there are always reasons why a trader might sell, in any conditions. But, scared traders won’t buy! This erases any buying pressure that might cushion a fall for a failing stock. Beyond that, though, another asymmetric factor is the other side of our thought experiment. Let’s say I get short at 10, and it falls to 9.50. I’m happy, once again, but what about the trader on the other side of my trade? I can think of these four cases this time:
- The other trader bought the stock from me to get long, but sells their position to cut their loss. If they’re emotional they might even get short, themselves. Selling pressure == good for me.
- The other trader bought the stock from me to get long, and wants to cut their losses. They have big brass ones, though, and hold out. No effect on the stock for now. But, if the price ever gets to breakeven or shows a small profit, they may decide it’s time to end the pain. This is selling pressure that helps keep my short trade in the green.
- The other trader bought the stock from me to cover a short position, but obviously covered too soon. They get short again. Selling pressure!
- The other trader bought the stock from me to cover a short position, but obviously covered too soon. They walk away. No effect on the stock.
This represents a stronger bias than the set from the long case. Primarily because usually only a small proportion of trades are short, which is cases 3 and 4 from the long trade. On the other hand, every trader on the losing side of a falling stock wants to get out! So, a correct short position usually has a more going for it, in the short term anyway, than a correct long trade. In either case though, these effects are amplified by volume. The more shares have traded on the other side of the breakout, the more people are in the unfortunate positions I’ve outlined.
Point and Figure Charts… Yes, Please!
This brings me to point and figure charts. Their premise is surprisingly simple: It’s only an important level if the price is repelled signifcantly by it. It doesn’t matter how many trades there were. It doesn’t matter how much time has passed. It doesn’t even matter how much volume has traded. If the price is repeatedly repelled at a level, then that level is support or resistance.
This simple insight cuts through a lot of rationalization that traders often do. “It’s got good tone.” whatever that means… and on and on. Point and figure charts don’t even give you a chance to rationalize about your price action, because the chart will only change when the stock is significantly repelled from a level. Otherwise, it shows you next to nothing! Do you know why the box play works so often? Because, in order to form, the price clearly has to be repelled at two levels, multiple times. All geometric chart patterns (like triangles, etc) are based on a series of consistent, strong price reversals. Why not have a chart whose primary focus is to point out those events?
Another plus: Traders also have a way of paying careful attention to exact values. “I’ll put my stop at 14.23,” they might say, because that’s the tip of a nearby candlestick. Any book on TA will tell you that support and resistance falls in zones, and not at exact prices. Point and Figure charts help here, too, by only showing you granular blocks of movement. It helps you think about S/R correctly, by only showing you what you should be thinking about: price zones.
The more I think about PnF charts, the more excited I get about them. They seem to emphasize what I want to see, and de-emphasize the things that lead traders to make mistakes. I could go on and on, beyond what I’ve pointed out already: for instance, they hide narrow chop nearly as well as volume charts (wide chop does make it through the filter, though). They show more detail when a stock is volatile, and that’s arguably when you can use more detail the most. And on and on.
I’m still trying to get comfortable with reading them, and trading off of them, but I think I am getting there. Time will tell!
And, About Price…
I said earlier that Volume and Price are the two truths about a stock. Volume is pretty straightforward… it’s a count of shares trading. But, what is the price? Most people think it’s simple and straightforward, too, but I think they are oversimplifying.
I almost always see people talking about the current price of a stock in terms of the last print amount. But, that’s a meaningless historical record. It has no bearing on the price you can get now. It helps me a lot to remember that there is never one value I can call “the price” for a stock. There are always two values… the best bid and the best ask. One is the amount you can sell it for, and the other is the amount you can buy it for. It’s more complicated than that, even, in that it’s two-dimensional. The bid and ask both have a size that indicates how many shares are openly available for those amounts. Even worse, both dimensions of both values are constantly in flux!
Sometimes these two values are very similar, and other times they are quite spread out. They can move quite a bit without any trades actually taking place. I’ve spent a fair amount of time watching the bid and ask, in relation to the prints going by, and building mental models for what might be happening to explain it.
Example: people guess wrong all the time when they look at aggregate bid/ask volume metrics. They think a lot of volume at the bid is always selling pressure. But, what if it’s profit-takers taking advantage of a lot of buying pressure? The prints went off at the bid, but if they hadn’t, eager bidders would have gotten antsy and converted their limit orders to market orders. Then, it would have all looked like ask volume. Or, what if that volume actually came from block sales that a MM absorbed? As I’ve described elsewhere, that could lead to a price rise as the MM maneuvers to offload those shares at a higher price. By watching how the bid/ask moves, and how the size changes on each side as prints go by, you can form guesses about who might be participating, and what they might be doing.
Of course, I can never know if I’m right. And, any effect from my guesses will be very localized and short term. But, I do think it has increased my win rate on scalps quite a bit, as I’ve improved at it. Maybe more articles should be written on this aspect of trading. Maybe by me, even. But, not today… this article is already way too long. I should have invited the Trading Goddess over to add some pictures to it to keep you interested!
Richard, if you are getting into PnF charts, puck up Dorsey’s book. Its pretty much the bible for PnF.
yeah, I’m looking at that one and another one by Plessis which seems to do well in amazon.com reviews.
[...] Unlike Richard I’m still using old fashioned candlestick charts. I recently wrote an article on pimp moving averages, and how they helped me stay in a winning position longer. However, last week I was chopped to death. My PMAs would be pointing up/down, and by the time even the 5 pma flattened, I had already missed the ideal place to buy/sell. I was dying a death by a thousand cuts. [...]
richard: i don’t think the blog police would have allowed that…what they let the trading goddess do, and what they allow me and u to do are different…you would end up having to censor her posts…or maybe they just didn’t like my pics of “amateurs”…they prefer the glossy “pro” look
yeah, the blog police would freak out and tone her down, but she usually at least puts in a chart, or a company logo, or something. The most eye candy I opted for was a couple bullet lists and a table.
lol
[...] Great post by Richard at Move the Markets on getting back to basics [...]