Published in 2012 by a discretionary trader Adam Grimes, this book is all about the basics and logic about technical analysis in financial trading, why and how it works. Some say technical analysis works because everyone looks at the charts and anticipates the same way but Grimes goes back to the Dow chart of 1929 crash and shows how it looks like a book example. So go figure why it worked back then, maybe human nature hasn’t changed. The book is a walk-through guide to understand price action and technical charting.
Tho I’ve become more a systematic trader, I find it good to keep learning the principles of technical analysis that discretionary traders use, because one needs to build a system upon some rules and it’s easier to develop the rules by knowing how price action works.
I’ll list the topics that Adam Grimes goes through in his book.
Trends
How to define a trend, how to trade it and what to look out for. Momentum is a modern term for a shorter term trend. The game has got much faster now compared to the ’80s – ’90s thanks to technology and more market participants.
Pullbacks
How to trade them and when do they fail.
Trend analysis
The simplest form of deciding on the trend is the Dow Theory: higher highs and higher lows in uptrend; lower lows and lower highs in downtrend. How trends end.
Indicators
Some of the most used trend indicators are moving averages, DMI, ADX, MACD. Understanding the integrity of trend.
My own opinion is that all these examples look pretty good in books but one has to create a plan to manage risk and get out if the trade is not working out, be it a time or a price stop, change of a pattern etc. You just need to deal with the fact that market action is often random and trades may not work out as expected. Different types of trend lines. Trend lines need swings in the markets, in flat markets they are better avoided.
Rate of trend
Trends don’t run perfectly and often change the angle in its current direction; many draw multiple lines that help to better understand the rate of the trend.
Trading ranges
In a trading range the price is in equilibrium and price action more random than in trends. More times than not trading ranges are continuation patterns in a trend. The other possibility is a reversal range which could be overextension, momentum divergence or specific termination formations.
Support and resistance
These are potential areas not fixed lines. How do you know your support / resistance levels are better than random levels? How to trade them and where to place stops.
Breakouts
Most breakouts fail but if it works, one can ride a nice long trend. What to look for in a good breakout and how to read the character of the market.
Trading strategies
Never start trading a strategy blindly from a book. Adam Grimes brings up the most common but practical trading strategies that readers could use to brainstorm their own personal trading plans: fakeouts, pullbacks, breakouts and hybrids of those.
Multiple timeframe analysis
Higher timeframe can add confidence to a trade, filter out trades or set a target for it. Lower timeframes can add entry or exit points to higher timeframe patterns. Lower timeframe price action can suggest whether a support or resistance is going to hold or not on a higher timeframe. There is usually more noise on lower timeframes.
Relative strength
What is relative strength and how to use it. Coming out of a bear market, usually the new leaders of the next bull market will have more relative strength compared to the overall market.
Trade management
The need for an edge. Random walk markets. Placing the initial stop – sets the risk point and removes much of the emotions. You will always have a stop level at where you’re wrong and get out of the trade. This level is set at the time of entry. More in the book about setting price targets, portfolio considerations, correlated positions and maximum portfolio risk.
Risk management
Risk and position sizing
In your trading you need to know answers to the three questions:
1) Where to exit (profit and loss)?
2) How to manage trade in time?
3) How many shares on each position?
“Always know where you are getting out of the trade if you are wrong, before you get in.”
The author shows a good example with Monte Carlo analysis for fixed percentage risk, how a positive edge can play out very differently in thousands of runs with random distribution. Risking 2% of the account per trade, none of the runs experienced a greater than 75% drawdown nor went bankrupt, some runs went down a lot before recovering. In real life this could be very hard to deal with and shows again how even a positive edge with an expected future value can experience tough times thru different distribution of winners and losers. When risk was lifted to 10%, 15% and even 25%, the risks increased a lot. With 25% risk per trade, there was over 47% chance to go bankrupt as one would’ve been risking a quarter of the account on each trade. Risking 1-3% of your total account on a single trade seems to be the most optimal, of course it depends on the actual trading strategy, risk tolerance and expectations. PS. Risk is referred to as the amount from entry to “stop loss” level, not the total amount of a position.
Practical risks in trading
Without a real trading edge, everything else is a waste of time. If you don’t know what your edge is, you don’t have one.
Trading examples
Lots of trade examples for the strategies covered, successful and failed ones. Interesting to follow and understand the author’s technical approach.
The trader’s mind
The market is essentially designed to cause traders to do the wrong thing at the wrong time. Some topics covered are psychological challenges of the marketplace, evolutionary adaptions, cognitive biases, the random reinforcement problem, the enemy within emotions, intuition, flow and practical psychology.
Becoming a trader
The author lists up six faces of becoming a trader: pre-trader, novice trader, early competent trader, competent trader, proficient trader and experienced trader. Looking at my own development, I’d say I have come to somewhere between the competent trader and proficient trader in three years. But I consider my development process faster than the average – I’ve been fortunate to be able to learn and practice trading full-time from the beginning.
Some other considerations about becoming a trader in this book are: time, capital, teamwork, mentor, technology (software and hardware), a business and trading plan, record keeping and P&L.
My own takeaways
Some good points I wrote down for my own process from the book are:
- First you need to find your edge that is a positive expectancy in the market using your entry / exit strategy. Even if you have all the discipline, psychology and money management in place, you still need an edge in the markets to make money.
- As a small individual trader you don’t need to compete against large institutions with much more capital, computing power and skilled staff. You just don’t play their game, you can pick your own markets, timeframes and style that doesn’t fit large capital.
- Most of the time markets are random and buyers / sellers in balance, swinging price up and down without much of a move. Technical traders want to avoid such state of equilibrium cause the next move can be random.
- When one side starts to push prices due to some new information and the other side has lack of liquidity, the price will move out of the balance, creating patterns on a chart. Such imbalances create trends and opportunities.
- Studying chart patterns by plotting them on a paper by hand like it was normal still in the 90s, makes an aspiring trader learn it better; it makes the brain work differently than looking at the screen (discretionary trader).
- Wyckoff’s market cycles: 1) Accumulation: sideways action and smart money slowly buying without creating trends 2) Markup: classical uptrend when the public becomes aware of it 3) Distribution: smart money starts to dump their positions to weak hands 4) Markdown: the downtrend that follows distribution, the smart money may go short and buy back shares at lower prices. These cycles don’t always come in perfect order.
- The four trades (different technical styles of trading): 1) trend continuation (usually buying pullbacks or selling rallies) 2) Trend termination also known as reversals 3) Support or resistance holding (fake-outs) 4) Support or resistance failing (breakouts)
- Clean support / resistance levels actually make a good breakout possibility. Manage risk, no stop too close to it, overnight gaps may occur and price never looks back. If a S/R level gets tested more than 2-3 times, it’s a big chance it will not hold.
- Breakouts are a great start for a new trend but most breakouts fail. Trends fail when pullbacks fail. Most trends end by transitioning into trading ranges, usually the trend doesn’t reverse at once like parabolic climax or weak test of the previous trend extreme.
- Momentum divergences fail as often as they work. There will be several failing momentum divergences in a strong trend. The divergences need swings to work.
- With LMT orders you will always be in every losing trade but you will sometimes miss winners. Always know where you are getting out of the trade if you are wrong, before you get in.
- R is referred to risk. If a trade loses the expected risk amount, it’s -1R. If you win half the risk amount, it’s 0,5R. Monte Carlo analysis runs your expected value thru different variations of distribution.
- A losing trade is the cost of doing business, not risk IF you have a positive expectancy.
Overall a very good read and I got some useful ideas out of it. I recommend this book from Adam Grimes to anyone getting started or wanting to increase skill in technical analysis.
The Art and Science of Technical Analysis by Adam Grimes book link
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