The Handbook of Technical Analysis + Test Bank. Lim Mark Andrew
in fact represents a general comment on all forms of analysis. It is not unique to technical analysis!
Here is a little exercise in subjectivity associated with pattern recognition. See Figure 1.22. Without looking at Figure 1.23, try to see if you can figure out the trend changes by drawing simple trendlines. After you have finished, refer to Figure 1.23 to see if you have drawn the same trendlines as indicated on the chart.
Figure 1.22 A Basic 4-Hourly Bar Chart of USDCAD.
Source: MetaTrader 4
Figure 1.23 Trendline Analysis on the 4-Hourly USDCAD Bar Chart.
Source: MetaTrader 4
There will most likely be a difference in the points chosen in drawing the trendlines. The very fact that you can draw alternate trendlines introduces an element of subjectivity in identification, interpretation, and forecasting.
Now go back to Figure 1.22 and try to identify some chart patterns (if you know some). After you have finished, turn to Figure 1.24 to see if you have drawn the same patterns.
Figure 1.24 Chart Pattern Analysis on the 4-Hourly USDCAD Bar Chart.
Source: MetaTrader 4
Were there differences in the chart patterns drawn? Do not worry if there are differences. It is merely a consequence of subjectivity.
Subjectivity in Pattern Recognition Diminishes with Practice
Here is another example based on the same USDCAD chart. Were you aware of the subtle angular symmetries in the USDCAD? See Figure 1.25. Analysts also pay attention to the angles of ascent and descent in the markets. A novice may not be able to clearly identify chart patterns, trendlines, or angular patterns at the very beginning. But with enough practice, the pattern-recognition abilities will gradually improve, becoming more obvious as the skill in reading charts improves. As a consequence, the amount of subjectivity associated with identifying patterns will gradually diminish.
Figure 1.25 Angular Symmetries on the 4-Hourly USDCAD Bar Chart.
Source: MetaTrader 4
Refer to Figure 1.26. Here is the same chart of the USDCAD again. But this time, we see the underlying beauty and symmetry of price, tempered and forged by the expectation, psychology, biases, and emotions of all market participants. To a trained eye, a simple chart of price action is as beautiful as any work of art. For technical analysis is, in itself, an art.
Figure 1.26 Underlying Market Symmetry on the 4-Hourly USDCAD Bar Chart.
Source: MetaTrader 4
1.6 BASIC ASSUMPTIONS OF TECHNICAL ANALYSIS
Technical analysis is based on a few fundamental assumptions. The first assumption is that market action, which includes price action, reflects all known information in the markets. The market discounts everything except acts of God.
This means that the markets can only discount:
• Known information
• Expectations about known information
• Expectations about potential events
The market cannot discount:
• Unexpected events
• Unknown information
Market action is representative of the collective trading and investment decisions of all market participants, which directs the flow of supply and demand in the markets.
This implies that the technical analyst need only refer to the charting of market action, since all known information and expectation about such information has already been discounted by the markets. The actual cause or underlying reason driving demand or supply is irrelevant, as it is only the effect of such action that really matters, that is, prices rising or falling.
Some detractors of technical analysis contend that the assumption that all information is absorbed or discounted by the market is flawed. They argue that, with the exception of illegal insider trading, price cannot possibly discount an unexpectedly large block purchase of shares in the market before it occurs. The detractors are in fact perfectly correct in their contention, except for the fact that the markets do not actually discount unknown information or unexpected events. The market can only react to what is known or expected, which includes insider activity. It does not react to what is unknown or unexpected. Although insider information is nonpublic, it is still considered to be known information, since the action of insider buying and selling impacts market action and as such represents information in the markets.
It may be more realistic to think of the market as in a continuous process of assimilating and adjusting to new market information, rather than an unrealistic full-blown discounting of all information instantaneously.
What Are the Markets Really Discounting?
It is not merely news, economic releases, or corporate data that the markets are discounting. The assumption is that it discounts everything. This includes:
• Information about actual events
• Expectation about actual events
• Information about expected events
• Expectation about expected events
• Expectation about the possibility of unexpected events
Some also argue that there are many other forms of discounting like buying the rumor and selling on the fact. They are curious as to what the expectation should be in such a case. Should the expectation be that prices will appreciate once the good news is released or should the expectation be that prices will fall once the good news is public knowledge (since everyone is in fact selling on good news)? How would we know if the market is discounting the:
• Rumor itself
• Expectations about the rumor
• Expected good or bad news
• Actual news
In reality, the market discounts all of the above. Regardless of what the markets are discounting, be it quantifiable or otherwise, the end result is that price and markets action will ultimately reflect the collective expectation of all participants.
Market Discounting versus EMH
Efficient Market Hypothesis (EMH) states that for a market to efficiently discount and reflect all information perfectly, all of its participants must act on all information in the same rational manner instantaneously. Does this definition of EMH also apply the basic assumption in technical analysis that the market discounts everything?
Detractors of EMH contend that the act of discounting everything is not realistic or is largely impossible. They argue that the problem lies in the action taken by the participants. Not all participants will react to the same event or information in the same way, and in fact, some participants may act on it in a contrary fashion, that is, shorting the market rather than going long. They also argue that not all of the participants will react at the same time. Some will take preemptive action or act in anticipation of the event while other participants will act during the actual receipt of the information. There will also