Today I am starting an occasional series on one of the most
fascinating and essential topics in currency trading; the interaction between
the psychology of the market and the decisions of the individual trader. I hope
these observations are useful; reader comments are welcome.
Technical analysis is sometimes studied as if it contains a
grain of secret knowledge or portrays an intrinsic truth about currency
movements. Often it is said that a specific chart formation will produce a
specific price movement.
Technical analysis does nothing of the sort. A chart is a
reflection of past prices, nothing more. In itself a graph cannot predict
future price movements. A currency does not trade up or down because of a
formation on a chart. It moves because market participants make basic
assumptions about future price behavior based on the record of past price
action. A charted history of price action is the cumulative story of thousands
of trading decisions; it is a record of the past behavior of thousands of
individual traders.
Price information is meaningful only because trader's
decisions give it predictive power. A simple proof of the limited forward
intelligence of historical price action is the well attested notion that
fundamental developments always trump technical analysis. If the Federal
Reserve raises rates unexpectedly or the Chinese Government announces it will
no longer buy US Treasuries there is no chart formation that has ever existed
that will prevent the dollar from rocketing up in the first instance or
plummeting in the second.
Technical analysis does not produce price movement. I state
the obvious because in the endless attribution of trading cause and effect to
'the market' it is easy to lose sight of the actual composition of the
market--thousands of individual decision makers. The translation mechanism for
technical analysis runs from the information contained in a chart, through the
assessment of that information by market participants to the trading behavior
of those market participants.
Another way to approach this idea is to ask, just who is the
'market' and what is it trying to accomplish every day. It is likely that over
90% of the $3.2 trillion daily volume in the FX market is speculative. That
means that everyone in the market from the hedge fund trader with $1 billion
under management, to the euro trader on the Deutsche Bank interbank desk to the
retail trader in her study, is trying to do exactly the same thing, take home
daily trading profits.
Interestingly, the overall worldwide foreign exchange
trading volume in 2007, the year of the last survey, increased almost 50% from
the prior survey in 2004 of $1.9 trillion daily. The counterparty reporting
segment to which retail foreign exchange belongs boosted its share of turnover
to 40% from 33% according to Bank for International Settlements in Basel (BIS,
2007) which conducts the tri-annual survey.
To return to my previous point, if every market participant
is attempting to do the same thing, namely wring trading profits from the day's
activities, how do they all go about it?
The first thing every trader does, in New York, Tokyo,
London and in every land in between is to pull up charts and look for trading
opportunities. Every trader looking for profit is judging the same charts.
Everyone sees the same price history, and everyone identifies the same
potentially profitable chart formations. And, in the absence of other factors,
the majority of traders will come to the same trading conclusion based on the
observed chart formations.
If euro has been in an up channel for two weeks and is
approaching the bottom of the channel most traders looking for an opportunity
in euro will bet on the continuance of the up trend and the maintenance of the
channel. They will place buy orders just above the floor of the channel. And
much of the time the charts will have been proven correct, the euro will indeed
bounce from the floor of the channel. But it bounces not because, for instance,
the ECB is expected to raise rates at some future date, but because of the fit
between the goals, information and assumptions of the market's traders.
Traders need profits, all charts contain the same
information and all traders operate with similar assumptions about market
behavior based on chart formations. If enough traders place their buy orders
above the bottom of the channel it becomes likely that the euro will bounce off
the floor of the channel and continue the upward channel formation, barring
external events of course.
There is powerful self-fulfilling logic in technical
analysis, it works, because everyone trading believes it will work and makes
their trading decisions accordingly. For a retail trader this knowledge is the
most accessible and effective trading strategy that exists.