Common Fallacies And Misconceptions Of Price Action Trading

Introduction:

Price-action trading is, in the simplest possible terms, the buying and selling of items with the aim of turning a profit on the fluctuations of the cost; in other words, ‘buy low, sell high’. While this definition is so broad as to be useless (since almost any financial transaction can be considered as exploiting a ‘price action’ in one form or another), we will apply a more rigorous definition of price-action trading by restricting it to the realm of stocks, bonds, and other purely financial abstractions. With the revolutionary impact that technology has had upon the modern trading landscape, we have seen a dramatic shift in the mechanisms and methodologies by which traders apply traditional price-action trading strategies [1]. Some economists go so far as to decry certain tactics as wholly suspect, if not categorically obsolescent or even obsolete [2]. This article will investigate a brief history of price-action trading over the years before delving into the uncertainties and fallacies where antiquated principles of price-action trading have failed the test of time.

Price-Action Trading in More Detail:

Let us further define price-action trading as the practice of analyzing simple price movement of a given asset in order to speculatively purchase and sell that asset for profit. ‘Price movement’ simply describes fluctuations of a given asset’s price; the price of gold changes hourly, for example, as does almost any other commodity. Price action is a subset of the broader categories of technical and chart-pattern analysis, methods which seek consistencies and order in the often random-seeming changes of prices. While there are many tools used in the analyses surrounding price-action trading, the most common by far are the candlestick graph and the price bar, two graphical representations which not only show price over time, but which quantify and qualify the nature and scope of these changes. Most price-action trading, practically speaking, boils down to the study of past trends and patterns and seeks to correctly interpret (or, less-charitably phrased, guess) at future changes, backing these predictions with speculative purchases [3].

Common Misconceptions about Price-Action Trading:

Unfortunately, many individuals have warped the historical profitability (or, more importantly, the perception thereof) of price-action trading to self-aggrandize themselves, inflating their own reputations to convince investors to allow the unscrupulous individuals to manage their (the investors’) funds. Even though a price-action trader may be wildly successful and deeply experienced, with years of a proven track record of positive investments, that is no sure indicator of their future incisiveness; the market is constantly changing. Even though many established mechanisms for price-action trading deal heavily with the management and mitigation of risk, risk still remains a non-divorceable influence in the multi-factored of speculative financial trading [4].

Traditional floor-based stock exchanges, so often popularized in movies and TV as packed, cacophonous warehouses full of spasmodically-gesticulating and frenetically-shouting businessmen, have all but disappeared in the modern era of widespread, reliable internet use. With the end of this era of bumptious, face-to-face trading comes a veil of anonymity; the two people on either side of a transaction almost never meet and may never even know the other’s name. Through the loss of this personal connection, we also lose any realistic way to confirm the legitimacy of the actions of a given trader or their future strategies; in the era of the internet, it is more and more easy for anyone to say anything and still sound eminently qualified and reliable.

Furthermore, price-action trading is not nearly as precise as many wish to make it sound; rarely will you find two traders, even ones of long experience and similar habit, who will interpret the same dataset and reach the same (or similar conclusions). The number and nuance of the variables at work, along with one’s personal experiences and preferences, conspire to make analysis of price action a most subjective matter. Unfortunately, they are often the only possible tools by which one can predict future movements. While this article does not wish to wholly undermine their past, present, and future utility, it remains crucial for any prospective investor to remember the uncertainties at play in the market.

Common Fallacies of Price-Action Trading:

This article will further discuss two prominent research biases which are, unfortunately, far too often seen in discussions surrounding price-action trading. It is essential that any investor fully understand these fallacious arguments; those who fail to avoid the logic traps will find their portfolios suffering accordingly. This article will discuss survivorship biases and reporting biases.

– Survivorship bias

Survivorship bias is defined by cognitive scientists as a fundamental logical error committed in argumentation or research that focuses too heavily on entities which persist through the period of study. This, thereby, skews the data towards those survivors and discounts the influence of other component elements which, while they may not have survived, still may have had massively important impact on the outcome of the situation. Commonly paraphrased, the maxim “History is written by the victors” is a good example decrying survivorship bias (though perhaps not wholly in the same spirit).

Studies which fall prey to this bias often produce too-optimistic projections; when one ignores the hard realities of failure, one consigns oneself to the risk of repeating the contributing elements of those same failures. It is important to remember that though a price-action trading firm or individual may have done quite well for themselves in the long run, they are highly likely to also have a matching string of past failures; often, these failures (which, though they are a healthy and natural part of any portfolio, ought not be discounted) statistically comprise 75% of any given body of accounts [5].

– Reporting bias

Immunologists and epidemiologists describe reporting bias as the conditional suppression or volunteering of information. This may be conscious or unconscious, as individuals tend to be reluctant about disclosing certain facts that they consider embarrassing, irrelevant, or damaging. This is relevant to our financial discussion inasmuch as those who have had poor experiences in the past will have a marked tendency to underplay those incidents, focusing instead on the solely positive. A brutally honest outlook is crucial when selecting the individuals and methodologies one entrusts with one’s money.

Conclusion:

While countless individuals have doubtless profited immensely from actions which fit the patterns of price-action trading, many experts remain skeptical as to the relevance of their experiences [6]. Those who dismiss the validity of price-action trading point to potential flaws in common technical analysis methods, further arguing that apparently-profitable traders may only seem to be so massively successful merely in the absence of their contrasting, failed counterparts. In other words, a common argument is that even though we see a body of successful victors, what we do not see (and what can be of essential import) is the much larger, much more common body of those who have failed under the exact same circumstances.

As always, no amount of research can compensate for hard-won real life experience; time spent in the markets is always more valuable than academic discourse. Ultimately, of course, the results are all that matter; while one may doubt as to how an individual achieved their success, it is impossible to argue with a pile of money. Still, it is important to be responsibly skeptical of broad claims; price-action trading remains a hotly-debated and uncertain road to wealth.

REFERENCES:

1. Caitlin Zaloom (2003). Ambiguous numbers: Trading technologies and interpretation in financial markets. The Journal of the American Ethnological Society, Volume 30, Issue 2, page 261, May 2003.
2. Caitlin Zaloom, Ibid, pages 265-267.
3. Andrew Bary (2011). Pitfalls of the Currency Casino. Barron’s Online.
Retrieved 26th March 2012 from http://online.barrons.com/article/SB50001424052970204735204576246772527987918.html
4. Nassim Taleb (2001). Fooled by Randomness: The Hidden Role of Chance in Life and the Markets. New York, USA. Page 203. ISBN 1-58799-071-7.
5. Andrew Bary, Ibid.
6. William Fung and David A. Hsieh (1997). Survivorship Bias and Investment Style in the Returns of CTAs: The information content of performance track records. The Journal of Portfolio Management, Fall 1997, Volume 24, Issue 1, pages 30-41.