Always base decisions on the price/volume chart. All an indicator does is summarize the information already visible on the chart. While useful for highlighting patterns in price and volume behavior, indicators can never replace the depth of information on the original chart. When you summarize data, you sacrifice some of the attributes in order to highlight others — so an indicator never gives the full picture. Indicators have two main purposes:
- To act as a filter when screening stocks; and
- To act as a form of executive summary before you examine the price/volume chart in detail.
You will often see technical analysts repeating the mantra: the charts discount everything — and all information available to the market is reflected in the current price. I believe that the market often takes time to react to new data. We are not dealing with a vast super-computer that can detect and analyze the full implications of a minute change in market conditions. The market is driven by mass psychology and pulses with the ebb and flow of human emotions. Emotions may respond rapidly to extreme events, but normally change gradually over time. Individuals are seldom comfortable acting alone: the market is dominated by a vast herd instinct.
By appraising yourself of market conditions you can learn to anticipate the broad movement of the market. Study general market conditions, especially the supply and demand for money, which drives market prices. If there is no money to buy stocks, prices will fall. Likewise, if the market is awash with money, prices are likely to rise.
Try to avoid making predictions. The market can go up or down at any time — it is only the probability (of each move) that varies. When you make predictions, you may lock yourself into a position and be less open to evidence that you are wrong. Attempt to eliminate bias by presenting both possible signals (bull and bear) wherever practical.
We never know the outcome of a particular pattern or series of events in the market
with 100 per cent certainty. The best that we can hope to achieve is a probability
of around 80 per cent for any particular outcome. That means something unexpected will occur
at least one in five times.
My approach is to assign probabilities to each possible outcome. Assigning actual percentages would imply a degree of precision which, most of the time, is unachievable. Terms used are more general: "this is a strong signal"; "this is likely"; "expect this to follow"; "this is less likely to occur"; "this is unlikely"; and so on. Bear in mind that there are times, especially when the market is in equilibrium, when we may face several scenarios with fairly even probabilities.
Analysis is also separated into three time frames: short, intermediate and long-term. While one time frame may be clear, another could be uncertain. Obviously, we have the greatest chance of success when all three time frames are clear.
For further details, see About The Trading Diary.