The Reality of What Determines Price

06/29/2010 12:01 am EST

Focus: STRATEGIES

One of the things I wanted to do with these MoneyShow.com articles from the beginning was to lay out a lot of the foundation work for technical analysis—basically to spend a lot of time thinking about what actually works and why it should work. I had done something a little like this when I started writing my daily advisory letter, but it was much more focused and had a specific goal. In The Macro Report, I was explaining my methodology and thought process so that clients could understand my work. I think this generated a pretty interesting set of articles, but in these articles, I really wanted to do something with a much larger scope. 

Over the past several weeks, I have filled an entire legal pad with notes, building out a complete theoretical framework for technical analysis, starting with theory and progressing to psychology and tradable patterns in the market. This is something I have tried to do for over a decade, and I finally think I have something that makes sense, is internally consistent, and explains the price patterns we see. I’m looking forward to sharing much of this work here, and will also do my best to respond to comments. In addition, there is also a practical, applied component to this series of posts. I boiled the theoretical framework down to a small set of actual trading concepts and patterns. For the next month, a group of traders who sit near me are focusing on trading these patterns intraday, and our results after a few weeks will say a lot to either support or question the validity of this approach.

One of the things that has always fascinated me about markets and trading is epistemology—what do we know about the way markets move, how do we acquire that knowledge, and how do we know we know it? Too many times, people think about trading issues in very sloppy ways. It’s too easy to look at a chart after the fact and say “You could have bought there and could have sold there.” It’s too easy to think about one specific trade that was a big winner when the real question is what would happen if I do this trade a thousand times? It’s too easy to think about a pattern that looks like a winner, but couldn’t possibly be pulled out of the market in real time.  Real market knowledge must be robust and more or less universal in scope.

On the other extreme, there is a large body of very in-depth, very scientific research from the academic community that leads to very little practical application. Traders tend to completely discount academic work, which I think is a mistake. Many of the quantitative strategies being traded successfully had their roots in academic work, and academics have done a fantastic job of framing the questions that traders need to ask. We will also touch on some of the current academic work in these discussions, especially looking at some of the results that challenge our assumptions as traders.

So, let’s start today by thinking about how price is determined. If you ask someone this question, they will usually think for a minute and come up with something like “Buyers and sellers agree on a price.” This is one of the fundamental concepts of markets and trading, but I think it may be slightly flawed. If buyers and sellers agree that a price is the price, shouldn’t they be willing to take either side of the trade? If we agree that a share of RIMM is worth $52.23, what difference does it make if I buy or sell? In fact, shouldn’t I be willing to buy and (in the absence of transaction costs) immediately flip to a short position?

In reality, this is not the way it works. I am buying RIMM because I think it will be worth more than I paid for it at some point in the lifetime of my trade, which could be seconds to years. I would assume the person on the other side of my trade believes the opposite, but even that assumption may be flawed. Many times, we see someone selling a lot of stock at a specific price when he could obviously sell it at least a little higher, and we assume that person is an idiot. Actually, we don’t know. Perhaps that trade is part of a pair trade. If the guy selling RIMM is doing a relative value play and buying AAPL at the same time, he literally doesn’t care if RIMM goes up or down because he is only trading that spread. Maybe I am buying the stock, intending to hold it five minutes, and the guy on the other side of my trade is selling a long position he has held for two years. The point is that we just don’t know who is on the other side of our trade or what their motivations are, and assuming both parties have a simple directional outlook, each trade is actually more representative of disagreement over future value than of a momentary agreement over current value. This is a small, but important distinction.

In a future article, we will look at what happens when we assemble records of individual trades, first in the form of the tape and then into charts.

By Adam Grimes, trader at SMB Capital and author of The Macro Report

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