What Technical Indicators Don't Do

They don't tell you what is going to happen next, at least not on a trade-by-trade basis. To many of you, it may seem as if I've just contradicted myself (see Part I). How can an indicator give you an edge, but at the same time not tell you what is going to happen next? Actually, there's a very simple explanation for this phenomenon.

The markets produce behavior patterns. The patterns repeat themselves over and over again. They can look and measure exactly the same from one occurrence of a particular pattern to the next. The presence of a pattern implies a consistent outcome. In other words, if the pattern is the same, the outcome to the pattern should also be the same. Unfortunately, this is not the case with the markets. The reason is, all of the patterns are composed of individual traders -- any one of whom, at any particular moment, can act as a force on prices in a way that is inconsistent with the expected outcome of any particular pattern.

The principles at work here aren't really any different than the principles that underlie the outcome of a series of coin flips. For example, if you flipped an evenly weighted coin 1000 times, you could expect an outcome of roughly 500 heads and 500 tails. For every sample set of 1000 flips, you can reasonably expect the same 50/50 outcome. We can define the results of a large sample size of flips as a pattern with a statistical reliable outcome.

The statistical reliable outcome is at the macro level (the entire sample size). However, at the micro level (flip by individual flip) there's no statistical relationship. Here's what I mean: If, in the course of flipping the coin a 1000 times, heads came up 10 times in a row, does this streak of heads have any bearing on the next flip? No, it does not. The odds of seeing heads on the next flip is still 50/50. In other words, there's a completely random distribution between heads and tails over any given series of flips.

Technical indicators work the same way. No matter how good any particular edge may be, there's still a random distribution between wins and losses in any given series of occurrences of that edge. For example, if, as a result of past performance, you found an edge that produced winning traders 70% of the time, is there any way you could know in advance which seven trades are going to be the winners and which three trades are going to be the losers, out of the next 10 occurrences of that edge? Not unless you had a way of reading the mind of every individual participating or who had the potential to participate in that market.

Furthermore, if outcomes of the last two occurrences of your edge were winners, does that mean the next trade will be a winner? There's really no way to know. Why? Because it only takes one trader somewhere in the world to come into the market with enough volume to negate the expected outcome of any edge, regardless of how convinced you may be that it's going to work. And vice versa, if the last two outcomes were losers, does that mean that the next trade will be a loser? Again, there's no way to know.

Technical indicators get you into the collective mind of the market, to give you a statistically reliable outcome for any given edge over a large sample size. They do not get you into the mind of each individual trader participating in any given market, to tell you what the outcome will be for each specific occurrence of that edge.

What Are The Psychological Implications?

Here's where the interface difficulties I referred to above come into play: On the one hand, we have technical indicators that provide us with this never-ending stream of opportunities to do something on our own behalf. However, these opportunities exist within a context of patterns that appear to be exactly the same. However, within these patterns are individual forces that cause the outcome of each pattern to be unique and random, with no relationship to the last outcome, or the next.

On the other hand, to effectively take advantage of these opportunities, you have to be able to execute your trades properly -- meaning you have to keep your mind focused in a way that causes you to do exactly what you need to do, when you need to do it, without fear, hesitation, internal argument or conflict. This is no easy task.

Our minds have two inherent design characteristics:

1. to associate, and
   

2. to avoid pain

This makes taking advantage of this never-ending stream of opportunities extremely difficult.

The first characteristic we will look at is our natural tendency to associate. Our minds seem to be "wired" so that we automatically link or associate situations, circumstances and events that have "similar" qualities and characteristics in a way that causes us to think, assume or believe we that know what will happen next. Of course, this characteristic can have a profound influence how we live our everyday lives, but it's not always that easy to attribute the effects of what we experience to this source. However, when it comes to trading, the effects of allowing our minds to associate two "seemingly" identical events that in reality have "unique," unrelated outcomes, are usually very dramatic and inescapable.

For example, let's look at a hypothetical trader who discovered or somehow acquired an edge. Keep in mind that we are defining an edge as a higher probability of one thing happening over another. He decides to start trading this edge and his first three trades turn out to be winners. The market is now setting up in a way that indicates his edge is present again.

Is this next trade going to be a winner or a loser? The reality is he doesn't know. He doesn't know because, as I explained above, there's a random distribution between wins and losses on any given set of variables that define an edge. And the reason there's a random distribution is because it only takes one trader somewhere in the world to do something that negates the positive outcome of his edge -- or any edge, for that matter. However, because of the last three trades the situation doesn't feel like he doesn't know what will happen next. In fact, it feels quite the opposite: He's virtually convinced a winner is coming his way.

What we have here is a huge gap between what's possible from the market's perspective, which is virtually anything -- and what's possible from his personal perspective, which is only one thing. This gap is caused by the mind's natural tendency to associate. This is something everyone is susceptible to, until we learn how to think like a trader. We'll look at the underlying dynamics of this characteristic a little closer.

The fourth occurrence of his edge came from the same pattern that produced the last three winning trades. Because of the similarity of the situation the "now moment" edge will automatically and instantaneously get linked to the memory of those last three trades. I say automatic because this process does not require any conscious decision-making on his part. Since the last three trades were winners, I am going to assume that the experiences caused him to be elated. If that's the case, the instant his mind connects the "now moment" (seemingly identical situation) with his memories, the same feelings of elation will flood his body and mind, making it seem as if he's already won. His previous experience then becomes his "now moment" reality.

The problem is the market may not share that reality. He may feel as if he's already won, but the market hasn't spoken yet. Certainly one possibility is that it could move in the opposite direction of his edge. If it's possible for the market to move in the opposite direction of his edge, then the outcome of his edge is uncertain. If the outcome is uncertain, then there's a genuine risk of being wrong and losing money. However, his current state of mind makes it virtually impossible to appropriately take these risks into consideration.

In Part III, I look at the consequences of believing we know what will happen next.

For The Best Trading Books, Video Courses and Software To Improve Your Trading Click Here