PAST PRICES ARE THE BEST INDICATION OF THE FUTURE PRICES

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MARKET PSYCHOLOGY AND TECHNICAL ANALYSIS

Another kind of academic post here. Got to make you people think I know what I’m talking about. Bear with the references.

Behavioral Finance very much links in with the psychology behind technical analysis. An article by Konstantinidis, Katarachia, Borovas and Voutsa (2012) looks at how the supremacy of Efficient Market Hypothesis (the idea the markets are random) has come to an end due to the emergence of Behavioral Finance. The weakness of EMH as a framework has given way to a more scientific approach of investing. The article suggests that rational investing based on efficient markets or the value of the underlying assets contradicts investors’ psychology. Evidence of this is shown by such events as the dot com bubble, where internet based companies with little or no net worth where being traded at prices well above what they should.

just like sheep

herd mentality tradingHerding is one of the heuristics described in the article by Konstantinidis et al (2012). Herding behavior suggests that people will be doing what other people are doing rather than using the information they have. This contradicts the theory of ‘random walk’ in that when mass investment begins to follow herd behavior the price is consequently driven in that particular direction.

This happens over time until the bubble has burst or profits start to be taken. However way it is looked at it does not suggest an equal chance of up or down movement. This suggests that when a trend is started, until otherwise broken, people will follow it.

This type of behavior clearly also contradicts the views of fundamental analyst who focus on the underlying assets and cash flow. The article suggests that investors are human beings and cannot just be cut off from their own investing past. For humans past actions are an important part of their own history. Therefore, in this perspective, past prices and past decision making behaviour cannot be disregarded as a forecast of future behaviour.

behavioral finance

The study of behavior and psychology and its link to technical analysis is increasing. It has been recognised by the Market Technicians Association (USA) and also the Society of Technical Analyst (UK) and Societies in Singapore (all of which are influential bodies). People in the markets however organised they might be can still experience pleasure and pain and also are susceptible to fear and greed. The mixture of all these emotions creates sentiment within the market. Market sentiment is much like a tide in which the securities are floating. When sentiment is high then the markets tend to be pushed higher and vice versa. Before anyone tries to play a part in the financial markets they must be proactive and try to get a feeling for the sentiment in the market.

So why has behavioral finance become an important factor for investments? Most of classical economics was based on the idea of that economically people are rational. It was assumed that people analysed data in a rational way, disregarding emotions and in a logical manner (Rationally Economic Man or The REM). Only when it was in there interest would they then transact.

When the highs and lows of trading in the financial markets begin to affect the investors we can actually observe that these people do not always act rationally and the assumption of The REM no longer applies. Decision makings are highly influenced by emotions (Azzopardi, 2010).

Behavioural technical analysis is used mainly when looking at basic technical indicators such as trend lines, Fibonacci retracements and analysing market sentiment.

Menkhoff (2010, p.2573) in his article states;

“What we find most significant is the relation of technical analysis with the view that prices are heavily determined by psychological influences. Consequently, technicians apply trend-following behavior”.

trader psychologyThis statement is supported by Murphy (1999). Murphy also suggests that a lot of TA is has to do with the study of human psychology. The principles used when analysing price charts show the bullish or bearish psychology of the market. The assumption is made that human psychology tends not to change, therefore, because identification of these patterns has proved successful in the past then they will continue to do so in the future. To put it in simpler terms Murphy (1999, p.5) suggests that history repeats itself and …”the key to understanding the future lies in a study of the past”. This statement is quite contrary to the principles previously looked at in the EMH.

The number one mover of price is market sentiment. Sentiment moves within the groups and crowds which make up the financial markets. This crowd sentiment can be noticed within the charts of the financial markets in the form of trend lines.

Trend lines are a very simplistic way to view which direction a particular market or security is heading. Although very simple and non-mathematical, trend lines are one of, if not the most important tool in any Chartist’s arsenal. Knowing which way a trend is heading or if a trend is failing gives a base knowledge that can then be built upon to make an informed investment decision. Trend lines can be used in the long term (monthly) or short term analysis from minutes to days. With regards to forecasting, a trend line can be used for two things. Firstly, if a price is heading towards the trend line, for example, falling to a certain psychological boundary this can provide support that suggests price may be ready to move back up. Secondly, a break through the support zone may suggest that the market sentiment is changing for a particular security. For example, an upward trend that fails to continue after its short retracement may indicate demand for the asset is weakening and the price may fall or head into sideward indecisive movement (Plummer, 1998) and (Mills, 1992)

Figure 3

forex trend lines

Figure 3 shows examples as to how trend lines can be found in market prices. The red lines are the trend lines (top support and bottom resistance). We can see clearly the areas where the herd mentality of the market kicks and and turns the market around. When price nears the red line, it retraces a number of times before actually breaking through. Some real good opportunities here to make some profit. I advise coupling this with some candle stick chart pattern observations to place your trades.

To establish a trend line using real time data firstly there needs to be two significant retracement points established in continuous data. Then a line can be drawn between the peaks/bottoms of this chart data and extended in order to forecast where future major retracement may occur.

 

 

 

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