The Psychology of Technical Analysis Page 1

The Psychology of Technical Analysis

A chapter-wise review

The Psychology of Technical Analysis Page 2

Table of Contents Introduction ............................................................................................................................................ 3

Rational Expectations Hypothesis ........................................................................................................... 5

Objective of Technical Analysis ............................................................................................................... 6

Crowd behaviour ..................................................................................................................................... 7

Trendlines ............................................................................................................................................... 9

Trend-line break .............................................................................................................................. 9

Head and Shoulders ...................................................................................................................... 10

Multiple top/bottom ..................................................................................................................... 10

The Elliot Wave Principal ...................................................................................................................... 12

Indicators of investor behaviour ........................................................................................................... 14

Volume and Open Interest ............................................................................................................ 14

Re-tests ......................................................................................................................................... 14

Momentum ................................................................................................................................... 14

The Advance-Decline Index ........................................................................................................... 15

The Psychology of Technical Analysis Page 3

Introduction Evolution is the unfolding of order and complexity in the process of learning.

We have discussed various styles of investing, including one based on technical

analysis. Technical analysis flies in the face of the efficient-market

hypothesis. EMH says that the prices of assets already reflect all past publicly available

information. However, by using technical analysis, one is trying to use past data to

project future prices, something that wouldn’t be possible under EMH.

Even if EMH were to be true for individuals, people behave differently when they are in

groups. Sometimes a person will be relatively individualistic and at other times the same

person will be relatively willing to conform to expectations imposed by others. Individual

behaviour is not easily predictable, but group behaviour is.

Over the next few posts, I will be reviewing chapters, in sequence, of the book: The

Psychology of Technical Analysis. Hope you will join me in the journey towards

discovering the secrets of technical analysis!

Aren’t investors supposed to behave rationally at all times? What is the reason behind

seemingly intelligent and rational individuals caving in to heard-instinct? The simple truth

is that membership of a crowd causes people to behave differently from the way that

they would in isolation.

In fact, herd-instinct is hardwired into our brains. Our brain stem (the innermost part of

the brain) that is primarily concerned with instinctive behaviour, developed over 250

million years ago, compared to our neo-cortex (which allows us to be aware of the

thought process itself and to anticipate the future/recreate the past) that developed only

during the last 50 million years or so. The operation of the neo-cortex is all too easily

suppressed by the emergence of a crowd mentality. As the crowd comes into being, the

brain stem and the limbic system hold sway.

Membership of a crowd involves the abrogation of personal responsibility to some

degree. A crowd tends to behave in a non-rational way and forces its members to do the

same. For most people, some form of crowd pressure provides a major motivating force

in their social, economic and political activities.

So in essence, a crowd is a self-organized entity defined by a common purpose. Once a

crowd is formed, it will react to new pieces of information from the environment.

Feedback loops are created and leaders emerge. The feedback loops create stable

The Psychology of Technical Analysis Page 4

fluctuations (limit cycles) in the relationship between the crowd and the environment.

These limit cycles are subjected to shocks and the crowd readjusts to deal with

unfamiliar events. Understanding limit cycles and the readjustment process is key to

understanding and predicting the the overall behaviour of the crowd.

Related articles

Don’t Condemn Your Instincts (psychologytoday.com)

Flaws of the Brain: Why Certainty Might Not Be as Certain as You Think

(healthheralds.wordpress.com)

Hidden Flaws in Strategy (ayeshanaveed.wordpress.com)

Shiller: More Expectations Theory, Less Efficient Market Hypothesis (ritholtz.com)

The Psychology of Technical Analysis Page 5

Rational Expectations Hypothesis A technical analyst knows the price of everything and the value of nothing.

The Rational Expectations Hypothesis is based on three interlinked assumptions:

1. Individuals do not behave irrationally

2. Individuals learn from their mistakes

3. Individuals arrive at their decisions independently of one another

However, REH fails in the real world. Natural forces encourage people to herd together

as groups. Groups behave as single organisms that respond in predictable ways to

new information, have their own emotional cycles and follow a definable path of growth

and decay. This is the rationale for technical analysis.

Technical analysis assumes that prices reflect the entirety of investors’ expectations of

the fundamentals (both economic and company specific). Financial markets will always

be trying to anticipate the future and hence market prices precede changes in

fundamental conditions. And most importantly, each price movement is mathematically

related to preceding price movements.

Related articles

When Does Technical Analysis Work (businessinsider.com)

Joe Stiglitz and Joe Gagnon Debate QEII (rortybomb.wordpress.com)

The Upside of Irrationality by Dan Ariely (neurosciencemarketing.com)

The Psychology of Technical Analysis Page 6

Objective of Technical Analysis When an individual buys or sells securities, an emotional commitment is being made.

The battle between the bulls and the bears is what creates a market for securities.

Without the presence of this constant state of conflict, there would be no graduated price

movements: prices would jump up and down randomly and no one would trade.

When an investor buys/sells securities, he accepts one of the two crowds’ beliefs about

the future trend in prices and identifies strongly with other members of the same crowd

(there are exceptions to this, however they form a sophisticated niche). An investor is a

committed crowd member. Because of this, as a price trend develops, individual trading

decisions become increasingly non-rational. Ultimately, extremes in optimism or

pessimism occur, creating the conditions for a reversal.

The objectives of technical analysis is to keep a close watch on what other investors are

saying and doing and when a vast majority are saying and doing the same thing, do the

reverse. The more people who believe in a trend, the fewer people there are left to

perpetuate it.

Related articles

Choosing Challenge Over Security – How Predictability Can End Discovery in

Committed Relationships (psychologytoday.com)

The Psychology of Technical Analysis Page 7

Crowd behaviour Greed is the fear of missing further profits.

The objective of a crowd in the stock market is to influence prices: the bullish crowd will

try to force prices up while the bearish crowd will try to force prices down. The sentiment

of the crowd usually turns prior to price reversals. Hence, just before market peaks,

sentiment will begin to deteriorate as the percentage increase in price falls.

The price-sentiment limit cycle is prone to shocks. Shocks occur because of a sudden

divergence between current price movements and expected price movements. Shocks

can be either pro-trend or contra-trend. Pro-trend shocks almost always destroy the

unsuccessful crowd. However a contra-trend shock will initially cause prices to fall which

results in falling sentiment. Eventually, the fall in prices begin to slow and

encourages bear closing. This, in turn, causes prices to rise and hence a reversal in

sentiment.

The disintegration phase of either a bull or bear cycle will occur very quickly. The fear of

not making profits is of a different order of magnitude from the fear of actually losing

money. This implies that investors prefer to hold stock rather than short positions. The

long-bias means that when a bear market begins, not only do very few investors

anticipate the fall, but also there is very little resistance to falling prices. Therefore, bear

phases take a shorter period of time and are steeper than bull phases.

Financial markets exhibit crowd behaviour. A crowd is a dynamic system. A dynamic

system can be expressed as a system of spirals. Hence, it follows that if we can identify

the presence of an unstable cycle in price movements, we should be able to calculate

the precise price targets. The life cycle of a positive shock goes something like this: the

initial market reaction that establishes a new trend or the resumption of an old one, a

reversal under a spiral mechanism and finally, a jump in a dynamic move. The final jump

is 2.618 (the Golden Ratio) times the length of the last wave of the base pattern that

precedes it.

The actual shape of a price pulse will be distorted by higher-order trends. However, in

practice, any price movement subdivides into three phases: the first two phases

constitute either a top or base pattern. The third phase consists of a dynamic impulse

wave. Subsidiary fluctuations occur because this three-wave pattern is repeated at all

levels of the hierarchy.

The Psychology of Technical Analysis Page 8

Related articles

Turning Points (July 2011, 2nd issue) (dowlliott.wordpress.com)

The Worry Meter May Overlook Some Warning Signs (nytimes.com)

5 Factors That Drive Stock Prices (money.usnews.com)

Nature by Numbers (ritholtz.com)

Euclid’s Ratio (triangulations.wordpress.com)

The Psychology of Technical Analysis Page 9

Trendlines

There are three categories of price patterns that yield profitable signals.

Trend-line break

This signal is given when the market price level penetrates the extension of a straight

line drawn through successive troughs (in a rising market) or successive peaks (in a

falling market).

The Psychology of Technical Analysis Page 10

Head and Shoulders

The H&S formation is similar in

shape to a silhouette of a person’s

head and shoulders. In the case of a

top formation, the ‘left shoulder’ is

formed by the period of price

weakness just prior to the market

moving to a new high; the ‘head’ is

formed by the new high itself; and

the ‘right shoulder’ is formed by a

period of price strength just after the new height. The base of both the left and right

shoulder occur at roughly the same price levels – you can draw a ‘neckline’ between

the two. A sell signal is generated when prices penetrate the neckline.

Multiple top/bottom

The Psychology of Technical Analysis Page 11

A trading signal is generated when the price bounces away from a particular level at

least twice. At market peaks, such a pattern is called the double top.

Related articles

That Little Itch Should Be Telling You Something (blogs.wsj.com)

When Does Technical Analysis Work (businessinsider.com)

The Psychology of Technical Analysis Page 12

The Elliot Wave Principal Stock market averages rise in 5 ‘waves’ and fall in 3 ‘waves’

The Elliot Wave Principal (EWP) has a strong following amongst technical traders.

However, nobody, including Elliot himself, has been able to explain why it works and

remains an extraordinarily complex system to apply.

EWP applies to all degrees of price movements. In a 5-3 bull/bear cycle, the first 5

waves themselves are composed of smaller 5-3 bull/bear cycles, etc. So each 5-3 cycle

is actually part of a larger, higher-degree cycle.

Indications

The emergence of a 5-wave impulse pattern, either upwards or downwards, indicates

the direction of the long-term trend. A rising 5-wave pattern after a sharp fall would

indicate further rises, while a falling 5-wave pattern after a sharp rise would indicate

further loses.

Within each 5-wave movement:

Wave 4 will not penetrate below the peak of wave 2.

Wave 3 is often the longest, but never the shortest of the 5 waves the constitute

the whole movement

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Two of the three waves will be of equal length.

Within each 3-wave movement:

No ABC formation will ever fully retrace the preceding 5-wave formation of the

same degree.

Each correction will be at least as large and as long as all lower degree

corrections that preceded it.

Each correction tends to return to the price range spanned by a corrective wave

of one degree lower (i.e., either to wave 2 or 4)

There are some variations that exist

Failures and extensions of the 5th wave

Diagonal triangles of the 5th wave

The three-phase A wave during corrections

Combined with the variations, the EWP covers the complete catalogue of price

movements.

Related articles

The Big Picture (June 2011 issue) (dowlliott.wordpress.com)

wave 2 complete (tradingtrends.wordpress.com)

Technical Analysis and Jimi Hendrix (belpointe.com)

The Psychology of Technical Analysis Page 14

Indicators of investor behaviour The greatest constraint on taking the right action in any market is doubt.

Volume and Open Interest

Volume is a direct measure of the amount of activity taking place in the market. Open

interest is a cumulative measure of the unclosed bull positions in a particular futures

market.

The level of Volume: The level of volume is indicative of people’s willingness to trade

and reflects their attitudes to the market. A low level of volume indicates an

unwillingness to open new positions and close old ones and reflects uncertainty about

the future direction of the market. On the other hand, a high level of volume indicates a

high degree of confidence in the future direction of the market.

The level of Open Interest: The level of OI is indicative of the liquidity of the market. if

OI is low, then there are very few profits to be taken or bad positions to be closed. At low

levels of OI, the market is illiquid and a new trade is likely to move the market.

Sudden changes in Volume and Open Interest: A sudden change in volume or OI is

indicative of a change in the price-sentiment relationship.

Direction of change in Volume and Open Interest: Rising volume suggest a growing

awareness of a higher-level trend and rising OI indicates a growing commitment to that

trend. Falling volume indicates the unwillingness to pursue the immediate trend and

falling OI suggests some reversal of sentiment.

Re-tests

A re-test is considered successful if prices move into new territory. If volume and OI do

not rise into high ground, then a non-confirmation takes place and an important trend

reversal is about to emerge (doubly true if OI falls as well). If both volume and OI fall as

prices move into new territory, then the following price reversal could be quite dramatic.

Falling OI, especially with higher volume, portends a sharp reversal in prices.

Momentum

A momentum index is a measure of the speed of change of the market. It can be a

1. simple percentage rate of change,

2. a deviation from a moving average, or

3. the relative strength index (RSI)

The Psychology of Technical Analysis Page 15

The biggest draw-back of momentum indices is that non-confirmation only generates a

signal when prices themselves actually start to reverse.

The Advance-Decline Index

The A/D index is a simple ratio of the number of stocks that have advanced to the

number of stocks that have declined. It acts as a proxy for the internal strength of the

market. Hence, if a market price index moves into new ground but the A/D doesn’t follow

suit, then the life expectancy of the movement may be limited and a severe setback may

ensue.

Related articles

Turning Points (July 2011, 4th issue)(dowlliott.wordpress.com)

Pay heed to sentiment in thin-volume August (marketwatch.com)