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What Really Drives Price Action in Any Market?
01/27/2011 1:01 am EST
Today, I will go over what I think drives price movement in the markets, why I hold these beliefs, and why I think it is important to understand the forces in price movement. Keep in mind the following theories are my opinions, not absolute fact. I believe in technical analysis much more than fundamental analysis, which will be reflected in this feature. There are people out there who will probably disagree with some of my statements below, which is fine. However, it is my hope that this information will provide value for readers and at least make people think.
People often ask, "Did fundamentals trump technicals on that trade?" or something along those lines. No offense to anyone out there, but that is a ridiculous question. There aren’t two boxers named "fundamental analysis" and "technical analysis" slugging it out for trading supremacy. Sometimes a major news announcement will shoot the price past a strong technical level, but that's why I don't enter trades right before a major news announcement. How do we measure "fundamentals" though? Does that mean an announcement today, the overall economic scope of a country over the past century, or something in between?
The reality is that the only force that moves prices in any market is the buying and selling of the financial instrument. For our purposes, we will use currency trading as an example, but this is true in all liquid, openly traded markets. Currency prices don't fluctuate on their own. They only move up when traders are willing to buy at a price higher than the current price, and they only move down when traders are willing to sell at a lower price. That sounds incredibly simple, but this is a very important fact to establish.
The reason it is important to determine that traders move the market is because this means no one can predict exactly where the market will go. Only probabilities at certain ranges can be determined, and usually the probabilities aren't overwhelming (they don't need to be). So the next time you hear someone say "XYZ is going to hit (x price) today," take those predictions with a massive grain of salt. They are saying that they know exactly what every trader is thinking, how much each of those traders will buy or sell, when they will buy or sell it, how the buying or selling of others will affect their own buying or selling, and how every trader will react to news announcements (both scheduled and unscheduled). Let's presume that some incredible genius figured out a way to create artificial intelligence that could solve each of those issues (and more I am leaving out). That model would assume that people are rational (like fundamental analysis does). Unfortunately, there is no limit to how irrational traders can act, individually and as a group. Therefore, it becomes obvious that no one person can ever know exactly where a price will go.
This seemingly endless list of variables, along with the irrational behavior of traders, is why I believe in technical analysis. Technical analysis uses various ratios and drawings that, in my opinion, are designed to measure the behavior of traders. We aren't trying to explain why they are doing what they do. As we discussed above, it is impossible to know what is going through every trader's brain. Instead, we are trying to determine certain levels where traders are more likely to act one way then another. With technical analysis, you can do basically the same thing every time. If you watch the patterns we post, they are basically the same patterns on different pairs every day. We try to eliminate as many random variables as we can. It is important to have a robust strategy, as we do, that works over all markets and all time frames. If a strategy only works on one financial instrument with one time frame, chances are that strategy won't work for long. After doing this, we can measure if we have an "edge" over a very large sample of trades. This isn't a guarantee that what once made money will always make money, but it is a lot better than nothing.
I am sure you can guess where this is going regarding fundamentals. Now there are different types of fundamental trading; if you trade based on an announcement that came out today, that is very different from a trader who looks at long-term macroeconomics. If you trade strictly on new announcements, that is a steep uphill battle. First of all, there are a lot of people out there who think the markets move ahead of the news (I am one of them). Second, markets can gap immediately after news announcements and can really hurt your execution with every broker. Third, markets often don't react according the exact numbers released in these news announcements. This goes back to the fact that traders are irrational and you have no idea how they will perceive news announcements. This can lead to wild swings, moves opposite of what makes sense, and other crazy events.
So how can someone consistently profit over a long period of time (at least 100 trades) by looking at individual news announcements? You got me. Even if a trader won at times, how can you be consistent when every reaction is so different? A trader who looks at the big picture over a longer period of time faces a similar problem. Sure, a currency may be "supposed" to move one way based on the economic measures a trader uses, but that only matters if traders buy or sell in that direction. How does this trader know that other traders will rationally interpret this information like he did? On top of that, one of my favorite trading quotations is "The markets can stay irrational much longer than your account can remain solvent." This means that the market could finally come around your way to the “rational” economic price, but you could already be knocked out by that point.
I could talk forever about this topic, but I will cut myself off for now. The point is that we don't know exactly why prices will move, where they will move, or why they even moved the way they did. That is why we take the approach of applying a consistent, technical method that has been tested over a long period of time. I will probably write a follow up at some point, because I have a lot more to say on this topic. Hopefully you enjoyed this article and it makes you think about the markets in a slightly different light.
By Bradley Gareiss, technical analyst, GFTForex.com
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