Matthew Kerkhoff, options expert and editor of Dow Theory Letters, continues his 14-part educational...
Why 'Only Price Matters' Traders Are Wrong
01/22/2016 7:00 am EST
That belief leaves out a couple of indicators that may be even more crucial, writes the staff at Netpicks.com.
All too frequently, traders narrow their focus to price movement alone. Certainly, what ultimately creates p/l in an account is the movement of price relative to a trader's changing position in the markets.
But it's easy to forget that price movement is precipitated by underlying changes to supply and demand. Therefore, if price movement is the effect, changes in the dynamic of supply and demand is the cause.
Trying to predict the future price movements by the effect alone is like trying to predict the future behavior of the wind based solely on the speed and direction it's currently blowing. It might be possible to get it right here and there, but if you want to make predictions with a greater degree of consistency and accuracy, you'll need to monitor air pressure as well. You'll need to monitor cause and effect.
How this applies to trading is simple. If you monitor price movements alone, you are taking in only two out of three pieces of information available from the exchange. These are price and time.
Clearly, it's not a requirement to know why price is moving in order to catch a move. However, in order to identify good opportunities with a greater degree of consistency, it is beneficial to look for cause.
Of course, the third piece of information is volume. To really see what is going on in the markets, we must answer the question of how volume of trade affects price. For example, if the market is trending upward, what does a move back down mean? Is it merely a temporary pullback before a continuation, or is it foretelling an imminent reversal?
With price and time alone, it could be difficult to accurately predict the outcome. But if you add volume as an element, things become clearer. There are various indicators you could use which include volume, but in its simplest form, if you see all the volume coming through is hitting the bid, there's a decent chance the move could be something more than just a temporary pullback.
In another example, price could be tightly range-bound. Watching price movement alone won't necessarily tell you whether the market is very quiet and just not trading much, or whether a battle is going on and it's poised to break. When you compare action like this over time, you'll notice more and more how price tends to move subsequent to the way participants react in terms of trades going through relative to price movement.
There is an issue in that a trader's attention may naturally be drawn to price movement. The human mind is highly evolved, and one of the things it's very good at is spotting movement. Back in our hunter-gatherer days, it was particularly advantageous to be able to quickly spot movement of either predators or prey. Come to think of it, it's probably the same reason why many people and perhaps this is truer for guys, enjoy action movies.
So when a trader monitors the market, instinctively their attention is drawn to the effect rather than the cause, and as I've already indicated, price movements alone do not give a complete picture of what is happening to the underlying supply and demand dynamics. Not all moves of equal magnitude have the same bearing on the immediate future of price. But if we're not careful, price leads the mind.
So what can you do to ensure you're not taken in by less consequential moves, or miss important ones? Most charts effectively highlight the movement of price, as do depth-of-market (DOM) order entry windows. Price movements alone can become mesmerizing.
There are two options depending on how you trade. The first and probably most straightforward is if you trade specific setup signals, you can add in cause to that signal. Obviously, the system specifics of what it's trying to capitalize on will determine the form of indicator used to account for volume.
The second option, if you're more of a discretionary trader, is to change your mindset completely. This is trickier, and clearly will require some practice.
You must first of all make sure that your charts allow you to monitor how trading activity is varying over time. This could be indicator-based or simply by watching a volume or tick chart. This just means that each candle or bar closes only when either a specified number of contracts are traded or a specified number of trades go through. This way, you can see how price moves relative to activity.
Once you know you can see trading activity, the change in mindset can happen. You must "hunt" for cause, then watch for effect. Over time, you will adjust and become less motivated by price movement alone.
Simply trading by price movements alone is possible, but what it fails to account for is the cause. If a trader can gain a better understanding of this critical market element, they will not only be able to identify profitable trades with greater accuracy, but they'll also be able to manage their positions better.This MoneyShow.com article was written by the staff at Netpicks.com.
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