Nick McDonald: Market timing with tea leaves

Technical traders are not right all the time. This is no different to fundamental trading, spread trading, arbitrage or any other form of trading. Photo / Thinkstock

Predict the turning point in the S&P 500 based on planetary alignment. Pinpoint the high in the Kiwi Dollar based on the moon and tides. Count the number of days using Fibonacci numbers to determine highs and lows in the market...
Sound realistic?

No wonder a small minority of people have a bad view of technical traders (those who look at charts to make their decisions) when a small minority of people trade the markets in the above ways. These are the witch doctors and sorcerers of the trading industry - a very, very small minority.

So when I hear people say things like "just because you see a pattern in the markets does not mean it will work" I recognise just how little they know about charting or technical trading. Hence, I will attempt the nigh on impossible and try to explain technical trading without the use of a single chart!

What is 'technical trading'? It's the term I prefer to use over the more popular 'technical analysis'. There are plenty of traders who 'analyse' the market, as compared to trade it. They usually work for banks and brokers and tell other people what to do with their hard-earned money when they are not actually doing it themselves. Technical "trading" involves actually placing the trade and not just analysing the market.
How does it work?

Firstly, let me dispel a few myths. Technical traders are not right all the time. This is no different to fundamental trading, spread trading, arbitrage or any other form of trading. The best traders simply make more money than they lose and that is the best we can aim for. Just because we see a technical pattern does not mean we have any certainty of what will happen next. Technical trading is based on increasing probability, NOT providing certainty. No one, and I mean strictly no one, ever knows what will happen next in the market.

So what do we do? What I do and teach people to do is study price action - not price patterns - looking for basic factors such as what is the trend or what is momentum. There are only three possible answers: Up trend, down trend or no trend (sideways with no momentum). Fundamentals cannot tell us this, only looking at a chart, technical, can help us establish momentum and trends.

As step one, a technical trader must decide if their style is to: a) trade with the trend b)trade against the trend or c) trade range bound or sideways markets. With that established they look at other factors to add to their trading strategy. I am a trend trader, meaning I look for momentum and trade with it. This is a bit like a rower deciding if they will paddle downstream, with the water's momentum, or if they will take the much more difficult and challenging route upstream.

Price trend/momentum is very simple to learn and recognise AND is the single most import tool in a technical trader's arsenal. Everything else becomes secondary. In second place of importance is to locate support and resistance levels. These are again very simple yet very significant.

They are points on a chart where on multiple occasions historically, price has either approached the level from below and failed to go higher (resistance) or approached from above and failed to go lower (forming support). That's it, so simple to recognise and use to our advantage since levels that have provided significant support/resistance levels in the past, have increased probability to do so again in the future.

When we combine these predetermined levels with strong trend momentum, we start to form the basis of a trading strategy. Then we continue to add more technical layers on top to increase our odds as much as possible on any given trade. But "there is no guarantee this will work" says the doubters and I remind them that "technical trading is based on increasing probability, NOT providing certainty". If you need certainty then you should be an accountant instead - the books will eventually balance. Trading shares no such traits.

All we are doing is trying to stack the odds in our favour and I've highlighted very basic theory behind a couple of the most important technical tools for studying price action.

This is not a 'tea leaves' predict-the-future-from-the-patterns profession. It is the study of price behaviour to look at what is actually happening in the market, what has happened before and how can we use this information to put extra probability in our favour towards what is more likely happen next.

Traders tend to pore over hundreds of charts before finding one with enough probability to decide we have a trade worth taking. We do not look at every chart and pretend to know where it is going next; perhaps 99 per centof the time we don't have a clue so we do not place a trade.

Comparing technical trading to fundamental trading, fundamentals tell you what should be happening but the charts tell you what is actually happening. How many fundamental traders/analysts/economists have you heard for the last five years telling us all that major stock indices are overvalued and 'should be' going down?

I can't make money by trading what markets fundamentally 'should be' doing. I can only make money by trading what is actually happening. That is what technical trading is about, studying the price momentum looking for places to join the trend. It also clearly shows me where there is no trend and therefore where to stand aside.

Nick McDonald is a New Zealander teaching everyday people how to trade the worlds markets via his company Trade With Precision.