Technical Analysis 101 Part 1
Thoughts on the physics of moving objects and breakout strategies
What does the price tell us? According to Paul Tudor Jones - everything. Price is king.
No matter which markets we operate in, timing is essential to our long-term success. We may be directionally correct, but to enter the market too early or too late. One of the most potent methods for timing the market is technical analysis in its purest form: price action on monthly and weekly charts.
This article is the first chapter of two dedicated to technical analysis. Today, we go back to school to study the physics of moving objects. Next week, we jump into the rabbit hole, where I will discuss time and probabilities.
Simplicity beats complexity
Every candlestick represents a picture of a capital flow driven by the present narrative and fundamentals. In other words, reflexivity in action.
Reflexivity describes the feedback loop between reality, circumstances, and perception. Reality is the market price, circumstances defining reality are the fundamentals, and perception of reality is the present narrative.
Asset prices react accordingly to narrative shifts, i.e., the prevalent consensus among market participants about the future of asset XYZ. The consensus defines the participants' actions—the direction of the capital they manage. Capital determines demand—which assets will grow more relative to others.
The price action sums it all up. Technical analysis is based on simple yet powerful principles. Despite that, we fail to apply those principles diligently.
The reasons for this dissonance lie within us:
We tend to complicate things because we believe that having more information leads to better analysis and, hence, more profitable trades.
We tend to complicate things to stroke our egos about how smart we are.
Look at the graph below:
Using many indicators and assuming the more, the better is a dangerous yet luring fallacy. The fewer, the better. Simplicity bets complexity—always.
This is an example of what NOT to do. The signal-to-noise ratio is inversely proportional to the number of indicators we use. So, strive for simplicity, not for complexity.
By technical analysis, the majority understand candle stick formations and countless indicators. However, the relationship is different - indicators are a means to an end. They are simply tools to analyze price movements.
Today, I'll introduce you to the Big Five of the price. They are the basis of all technical analysis tools - from classic resistances and supports to cutting-edge indicators that use chaos theory.
The Big Five of Technical Analysis
Every indicator is a derivative of price. Complex indicators represent the price as a higher-order derivative. However, we must be aware that the complexity and precision of the indicators do not correlate with their utility.
Big Five describes the essence of the price action. They provide a clear picture of price changes. Price comes with the following characteristics:
Direction - trend, where the price is moving. A trend is a directed continuous movement shifting from one with erratic price changes within narrow borders (range). The result is the constant repetition of trend - range - trend.
Magnitude - how far the price movement will go. The price makes extended movements (expansion) followed by those with a small magnitude (contraction). The result is an expansion-contraction-expansion loop.
Velocity – this is the rate of price change. Price alternates between periods of powerful impulsive movements for a short time (impulse) and weak ones lasting longer (consolidation). Thus, we get a repetition of an impulse-consolidation-impulse cycle.
Timing—when our thesis will play out, i.e., when the projected price level will be reached. Unlike the first three parameters, this one is not cyclical.
Credibility - how realistic is our scenario? Put another way: how likely is the price to reach the target set by the scenario?
These characteristics are the basis of technical analysis. They are recognized on charts of all assets, markets, and time frames, and all indicators measure them in some way.
The change of direction, magnitude, and velocity leads to the constant repetition of the following cycles:
trend - range - trend
expansion - contraction - expansion
impulse - consolidation - impulse
All markets follow this cyclicality of directional, sustained, and rapid movements with erratic, unstable, and weak movements. This cyclicality defines two states of the market: balance and imbalance.
Balance = consensus on price = erratic, unstable, and short-lived changes = price moves in a narrow range for a long time, meaning neither sellers nor buyers prevail. We have a balance between the two sides. The balance state is characterized by range, contraction, and consolidation.
Imbalance = lack of consensus on price = directional, extended, and swift changes = price moves directionally, which means that one party controls the situation. We have an imbalance dictated by the preponderance of sellers or buyers. The imbalance state is characterized by trend, expansion, and impulse.
I call the shift between balance and imbalance a phase transition. Simply put, this is a confirmed breakout above/below a significant price level that acts as a border of a range. The breach beyond the trend line indicates that the consensus among market participants is tilted to one side, i.e., an imbalance emerges.
The chart below shows Cameco Corporation’s price action on a monthly chart.
The green rectangles mark imbalance, while the red one balance. As you can see, the price has moved within a narrow limit, forming a rectangle during the balance phase. Here lies the strength of chart patterns on long-term charts.
A confirmed break-out signals a potential phase transition, i.e., the price action shifts from balance to imbalance. In other words, the probability of directional, extended, and rapid movement is in our favor.
In summary, the break-out strategy exploits the phase transition between balance and imbalance, which is why it is so powerful when applied correctly.
Final thoughts
In each market and time frame, the phase transition imbalance - balance - imbalance is observed. The result is trends-expansion-impulse followed by range-contraction-consolidation. The latter is recognized as chart patterns—rectangles, heads and shoulders, triangles, cups, and handles are some examples.
The three variables—direction, magnitude, and velocity—are quantitative and measurable. They are necessary parts of the analytical process but do not give the whole picture.
In markets, we always deal with multiple scenarios because they are complex adaptive systems with an (in)finite number of actors, and each of them is connected to the others in (in)finitely many ways. Therefore, scenario building is impossible without the knowledge of time and credibility. Next week, we shift gears and go full abstract, talking about time and probabilities.