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Focus On How Markets Move First, Then Why

Aug. 17, 2012 10:43 AM ET
Jay Norris profile picture
Jay Norris's Blog
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Unless you're a scientist, the average person does not need to see things from a different dimension, so we don't. If we thought about analyzing the day to day physical things we see from a different dimension, like a tree, or a bird, or your neighbor, it would seem silly, because there is really no reason for it. In fact, our senses -- our eyes, ears, and nose etc. - do a good job without having to analyze things. The dimension you see is the dimension you get, so to speak, and when things do change it occurs at a predictable rate such as the season changing, or a parent aging. And it is those day to day dimensions that our senses record which creates our perception. When it comes to defining market movement in the context of physical dimension however, our senses and the perceptions they've created are handicapped. The average person doesn't have much experience with the dynamics of market price movement. We're used to seeing things in proportion to ourselves and our surroundings in a dimension we're all familiar with: our physical world. In our world things grow and then they die, and that life cycle is a familiar dimension for us because man has experienced it for a very long time. We are very familiar with our physical world because for the most part everything is in proportion, and it's a pretty friendly environment for us - climate and temperature wise. We can't help but take the experiences of our physical world and apply them to everything else. And that is why initially we are at a disadvantage when it comes to trading. Rather than first learn how markets move, instead we focus on why they move.

Markets, like everything else on the planet, have a growth cycle. They are either growing, or contracting, or somewhere in between. And while a market product may be physical, its price is not. And that's why we need to think differently. We cannot think in terms of the limited growth cycles we're familiar with such as a tree, or a field of corn, or ourselves. The growth cycle of modern markets is much more dynamic than the growth patterns we are accustomed to. Because price moves so frequently, with its patterns perpetually changing shape on both a micro and macro level, there is definitely a dimension to it that we are not accustomed to. Making sense of market movement starts with accepting whatever price pattern a market is showing us. This is a very simple concept, but for many, much harder to implement. Just as we see an oak tree, and accept it's an oak tree; or we see a blackbird and we accept it's a blackbird; when we see a bullish price pattern on the Daily chart, we need to accept that there is a bullish pattern on that Daily chart. This acceptance of what is, and not what we think it should be, is an essential step to understanding how markets move. If you find yourself in disagreement with an existing price pattern it is going to be very difficult to find consistent success as a trader. Once you accept that price is always where it's supposed to be at that moment, it follows that price is an accurate reflection of its environment. Pattern is the "how" of price movement, while environment is the "why". If the growth pattern is a bullish -- one marked by higher lows and higher highs -- then the environment is positive and you would look for buy signals following price dips; if the growth pattern is bearish and price is showing lower highs and lower lows, then the environment is negative and you would look for sell signals following rallies. You can still pass on a trade in one pattern because a higher time frame pattern is divergent, and this just means you don't accept the risk of taking a trade in-line with that lower time frame pattern. This also brings up that patterns can exhibit different behavior on different dimensions - dimension referring to time-frame. For example the market's primary pattern can be bearish, but its secondary pattern bullish. We have a similar situation in the euro in Figure 1.

Figure 1

These are often great opportunities for traders because it is at those times when intermediate-term patterns shift in-line with longer-term patterns that we get the biggest price moves. The price pattern on the Daily chart is one of sizable secondary rallies followed by steep sell-offs in-line with the overall pattern. It's clearly showing a negative growth curve which reflects a bearish environment.

Figure 2

Differentiating between "how" markets move, which is to understand and respect price patterns, and "why" markets move which is a determination of economic environment should simplify our market analysis, not complicate it. Price pattern is a reflection of environment. If you have a bullish pattern you have a bullish economic environment and the same for a bearish price pattern. If you surmise that the environment is bearish yet the pattern is bullish, you are not accepting the pattern, and your idea is in conflict with the market. The 4-hour chart of the Euro in Figure 2 from this past week shows us a bullish pattern with the corrections being nearly equal. What we can say with some confidence before that last leg up is that the current environment for this micro pattern must be bullish. Once you understand that the pattern absolutely is a reflection of the fundamental environment, and that they support each other, you are going to put yourself in a better position as a trader. Rather than try to analyze last months or last quarter's economic data you can let the market itself analyze today and tomorrow's economic occurrences and have confidence that the current price pattern on the chart is showing you what the current economic environment is.

You may have noticed that the bullish 4-hour chart in Figure 2 can be called a sub-set of the bearish pattern and bearish environment in Figure 1. So the billion dollar question would be how do we know when that micro pattern on the 4-hour chart will shift in-line with the macro pattern on the Daily chart? We don't. But we do know that when the 4-hour pattern shifts lower that it will be in-line with the Daily pattern and we would shift ourselves from looking to buy dips in the short-term uptrend to selling rallies in the new short-term downtrend which has the benefit of being in-line with the macro pattern.

To see Jay Norris highlight trade set-ups and signals in live markets on Mondays & Thu's go to: Live Market Analysis. Jay is the author of "The Secret to Trading: Risk Tolerance Threshold Theory".

Trading involves substantial risk of loss and is not suitable for all investors!

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

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