Hobofinance.com

There are two ways of assessing a market’s future direction, both of which are necessary to trade well. The first method is fundamental analysis. The second is technical analysis.  Fundamental analysis looks at real world supply and demand figures for a certain commodity, as well as macro trends in production and consumption. For long term traders this is likely the best method to use to assess a commodity’s price direction, as fundamentals tend not to turn on a dime. Large price moves are usually foreshadowed by increasing fundamental imbalances. Take Crude Oil for example. For the last 6 years Crude has been making historical gains in price. For those who looked at Crude’s fundamentals 6 years ago, they would have learned that demand for Crude world wide is increasing steadily in western countries, and exponentially in developing countries like China and India. Supply has remained relatively flat and doesn’t look to increase any time soon.

There can always be kinks in a crude oil pipeline or widespread disease for certain crops which cause an immediate shortage, and therefore a rapid rise in prices. But these kinds of things are tough to capitalize on consistently. It amazes me sometimes how many people are not aware of how supply and demand influences price. I’ve noticed a common fear in people who are considering investing in a particular commodity. They often ask ‘what if something happens…to the supply?’ The irony is that what is bad for a commodity’s supply is great for its price. Most newbies stick to the long side (buy: assuming prices will rise, as opposed to short: expecting prices to fall) of a trade anyway, so supply disruptions tend to help rather than hinder their profit potential.

Technical analysis looks only at the price patterns of a commodity. Chart analysis in my opinion winds up being a kind of self-fulfilling prophecy. Many people say price patterns are predictive tools for future prices. I think this is absurd. Charts don’t predict the future, they summarize the past. If charts have any predictive accuracy it lies in two areas:
1.  The Reality of Trends
Future prices are a continuity of today’s prices, in that most of the players who enter the market tomorrow are aware of today’s prices. All of the players who exit the market tomorrow are aware of today’s prices. If prices fall today, tomorrow’s buyers may enter at these lower prices. If prices rise, it may be met with selling from those who made a profit. If prices rise rapidly, it may be met with greater buying as people become consumed with greed. Tomorrow’s prices begin where today’s prices end. This is a simple truism, but it is the essence of one of the most powerful technical trading systems around-Trend Following. Trends exist in markets, prices are not random. Tomorrow’s prices were influenced from today’s prices, and momentum begets momentum. Once a market establishes a trend it tends to remain trending. This leads to one of the oldest rules in trading, trade with the trend, or ‘the trend is your friend’. This can be such an effective method that there are major schools of trading that do nothing but set up automated trading programs that trigger a buy signal when prices rise above their moving average (the average of a certain number of previous closing price, usually 20 or 40 days), and a sell signal when prices move below. They are not concerned with anything but price, whether there is a fundamental explanation for a change in trend, or whether it’s merely a correction in an otherwise trending market. They care only about that price move and they make the trade every time without personal discretion, emotion, or concern for latest news stories.

2.  Groupthink
There are a whole host of technical indicators, too many to talk about here, and too many to care about. Most of them are crap, Rorschach tests that reveal whatever an analyst is looking for. All of these indicators do different operations on price to predict future price moves. The only value that these indicators have in my opinion is in the fact that many people use them. When many people observe the same indicators and trust them, they make similar trades. These indicators wind up being self-fulfilling by the mere fact of being used, not by predicting the future outside of the influence of many people who believe in the same system. That said, prices are extremely important if for no other reason than that people have memory. Price settlements reflect a battle between two powerful forces, buyers and sellers. When the price plummets, buyers who got burned and lost big don’t forget that loss quickly, and are unlikely to make that same mistake right away, leaving the market temporarily vulnerable for strong sellers to push prices lower. Trading isn’t about creating algorithms capable of dissecting an infinitely complex market, it’s about groupthink. Herd mentality. People get greedy and buy, people get scared and sell. The people who stand alone generally succeed, whereas those swayed by fads and news generally follow their herd off the cliff. Whatever tools you use and whatever time frame you trade in, your system should go beyond analyzing numbers. It should be able to quantify the power of buyers to buy, and the power of sellers to sell, when each group becomes exhausted, and when the other group will dominate. There are real people behind those numbers swayed by the same compulsions as the rest.