Tracking and Cracking The Indian Stock Market: The Foundation of Technical Analysis

Saturday, 21 March 2015

First Principles

Markets are highly random and are very, very close to being efficient.
It is impossible to make money trading without an edge.
Every edge we have is driven by an imbalance of buying and selling pressure.
The job of traders is to identify those points of imbalance and to restrict their activities in the markets to those times.
There are two competing forces at work in the market: mean reversion and range expansion.
These two forces express themselves in the market through the alternation of trends and trading ranges.

Traders usually view market action through charts, which are useful tools, but are only tools.
Trades broadly fall into with-trend and counter trend trades. These two categories require significantly different mind-sets and approaches to trade management.
There are only four technical trades. Some trades are blends of more than one trade, or an application of one trade to a structure in another time frame, but these are just refinements. At their root, all technical trades fall into one of these categories:
Trend continuation.
Trend termination.
Support and resistance holding.
Support and resistance failing.
Each of these trades is more appropriate at one phase of the market cycle than another. If you apply the wrong trade to current market conditions, you will lose.

Market structure refers to the pattern of relative highs and lows and the momentum behind the moves that created that pattern. Market structure is a more or less static element.
Price action refers to the actual movements of price within market structure. Price action is dynamic and ephemeral and must sometimes be inferred from market structure.
There are three critical areas of market structure to consider: trends, trading ranges, and the interfaces between the two.

Trends move in a series of with-trend impulse moves separated by retracement.
Retracement often contain lower time frame trends that run counter to the trading time frame trend.
Trends that run counter to the higher time frame trends tend to reverse.
Complex consolidations in trends are a reflection of the lower time frame trend structure and are common.

Trend terminations are usually set up by momentum divergences, and are confirmed by market structure. Do not attempt trend termination trades without clear evidence of a change of character.
Trends may terminate either into trading ranges or into trend reversals.
Trends end in one of two ways: by rolling over as the trend loses momentum, or in parabolic climaxes.

Trading ranges are defined by support and resistance zones, which may or may not be clean, exact levels.
Classic accumulation/distribution patterns are recognizable at the extremes of ranges.
Violation of support and resistance does not necessarily invalidate the trading range. It is possible that the range has simply expanded or moved to a new level.
Trading ranges serve a structural function in the higher time frame; higher time frame market structure can give a bias to the direction of the break from a trading range. In the absence of contradictory information, assume that any trading range is a continuation pattern.

Breakouts from trading ranges are volatile and are driven by disagreement over price.
The first pullback after a breakout is critical for assessing the strength of the nascent trend.
Breakout failures are far more common than successful breakouts.