“In financial markets, there are certain price levels that are more important and significant than others with regards to the amounts of supply and demand that exists at these levels. In addition, prices of securities are always trending. They are always doing one of three things…either going up, going down or staying the same as time progresses. BHT utilizes a common sense and simple methodology to identify these levels and trends. An understanding of these levels and trends will add Alpha to almost any investment process. “
-Mark Putrino, CMT
In its essence, my philosophy and methodology have evolved from my practice of is traditionally called “Technical Analysis”. Technical Analysis of the financial markets is not understood and is discredited by many in the trading world...and I can understand why. Most of the technical research I see is terrible. I see examples of this almost every day and this includes the research and insights that come from so called experts in the field. Analysts often seem to speak about their ‘analysis’ and come to conclusions with seemingly no understanding of just what exactly it is that they are analyzing. Traditional Chart Patterns are treated with an almost religious awe instead of the pictures of the changing dynamics of supply and demand that they are supposed to represent. Moving Averages are often discussed with a mindless herd mentality. As a result of this, I frequently hear people criticizing technical analysts and technical analysis.
Unfortunately, I would have to say that much of this criticism is justified. Most of the technical analysis that I see in the media is questionable at its best, and downright awful at its worst. Sometimes it is so bad, that I’m almost embarrassed to call myself a Technical Analyst. I even have issues with the term 'technical analysis' because I think it is out of date and vague. But I can also say that despite its name and terrible practitioners, I see proof every day that certain types this method of analysis is entirely valid and legitimate.
To me technical analysis is not about anything esoteric or mystical. It is about common sense and logic. If practiced correctly it is simply a methodology that tries to identify important trends and levels of supply and demand in the markets. I am not your typical technician. My years of experience trading illiquid securities have taught me how to identify meaningful trends and important levels of supply and demand in the markets. I don’t waste my time with esoteric or mystical things like Gann Angles or Astrology. In fact, I believe that they belong in the realm of UFOs or Bigfoot…fun to talk about but hard to believe.
My method is simple. I identify meaningful trends and important supply and demand levels in the markets. I believe that if you have an understanding of these dynamics it will add value to your investment process.
Fundamental, Efficient, and Random Voodoo
I find it funny when fundamental or quantitative analysts question the validity of technical analysis. Many times, these are the same academic types who cling with an almost religious fervor to the Random Walk Hypothesis or the Efficient Markets Theory despite the fact that the academic community is finally starting to figure out what traders have known since there has been trading. Now the Academic Community calls it ‘behavioral analysis’ because a bunch of egghead academics have finally come to understand that humans aren’t rational, and that emotions weigh into their decision-making process.
Let me let you in on a little secret. I have met many technicians who used to be fundamental analysts, but I have never met a fundamental analyst who used to be a technician. That is because as they gain experience and come to understand the markets, they eventually realize that something is only worth what someone else will pay you for it and that fundamental analysis is basically a waste of time. I personally know analysts that are proud to call themselves ‘fundamentalists’, and take pride in the fact that they spend countless hours studying balance sheets, income statements, 10-Qs, speaking to company managements and customers and so on and so on.
But guess what? When the markets blew up I also saw many of these same investors pathetically give away their stocks for a fraction of what they were ‘valued’ at. You may think your stock is worth $30 because if it had the same PE ratio as their peers that’s what it would be worth, but if the highest bid you can find is $15 then to me, it’s only worth $15.
Think about it. Every market bubble as well as every panic in financial history has been justified and validated by fundamental analysis! At the height of the Oil Bubble in the summer of 2008 when Oil was trading in the $140s, the highly paid fundamental Oil analysts at Goldman Sachs said Oil was worth $200 a barrel. I’m sure that whoever performed this ‘analysis’ spent 15 hour days 7 days a week working on this research and was paid millions for it. Six-months later Oil was trading in the $30s. That’s $30s-not $130s. Every competent technician that I know saw that the Bubble was about to burst and laughed when Goldman came out with this not so brilliant insight.
My Philosophy of Market Equilibrium Analysis
The popular misunderstanding of Technical Analysis is unfortunate because the methodology is, or essentially should be in my opinion, the study of supply and demand levels in a marketplace. I call my version and style of Technical Analysis “Market Equilibrium Analysis” and I consider myself a “Market Equilibrium Analyst”. I am certain that most sophisticated market participants will acknowledge the value of knowing at what price levels their rivals or potential counter parties on the other side of the trade are ‘hiding’ or have an interest. Analysis and study of supply and demand levels can give an astute analyst some sense of which way a given market will head in the future…at least in the short term. Obviously, this knowledge could add value to almost any investment process, including long term ‘buy and hold’ strategies.
Market Equilibrium Analysis is where the practical trumps the theoretical. If you want to hang out with a bunch of academics at Starbucks and drink some lame, overpriced fruit coffee and discusses Efficient Market Theory or the Random Walk Hypothesis that’s certainly your right. But…if you actually want to make money in the markets, you should pay close attention to important areas of supply and demand!
I spent twenty years as an Institutional Trader, and in that time there probably wasn’t a week that went by where I wasn’t faced with executing a very difficult trade. When you need to do things such as…
- Accumulate or sell a 500,000-share position of a stock that averages 20,000 shares trading volume on a typical day without moving the price or…
- Sell out the position of a top ten share holder three days before the earnings call without ‘spooking’ the market or...
- Sell a large position of an option that hasn’t traded in two months…
…then you will soon understand the advantages of understanding and implementing Equilibrium Analysis. Just like it’s been said that “there are no atheists in foxholes”, I can assure you that when real money is on the line there are no competent traders who don’t pay attention to important levels of supply and demand. Markets do indeed have memories, and successful traders know this.
The First Thing I look at…
When I am considering entering a large order in the stock market, the first thing that I look at is the levels of supply and demand (or support and resistance) which occur at different price level that may be important. Sometimes they can be levels from as recent as just a few days or weeks ago, but some levels can go back months and even years. Even a beginner or someone who has no familiarity with financials markets will be able to recognize important levels by a simple view of a chart.
For example, if a stock rallies from $10 to $20 then then goes back to $15, the resumes its rally and approaches $20 again a novice or someone who has no knowledge of the markets at all will be able to see that it is approaching a level of former importance. If you understand these dynamics, you can make accurate predictions where trends will most likely encounter resistance or support. It goes without saying that this could enhance your investment process. Important areas of support and resistance are everywhere.
I typically do not care about the (usually wrong) reasons that are given in the media or by fundamental analysts for why a market is moving or has stalled. I have the luxury of not having to justify the markets movement with some lame incorrect fundamental analysis. I am merely trying to take advantage of these moves and to understand where the important levels are. You need to remember that the market is always right, and the signals that it gives are never wrong. You may interpret them incorrectly, but that is not the markets fault.
Market Equilibrium Analysis can benefit virtually any type of investment strategy and be applied to almost any asset class as long as the market is liquid enough. This includes debt, equities, commodities and even other assets like real estate. Although the assets are very different, the human beings that are buying and selling them all share common emotional and psychological characteristics.
What are Support and Resistance Levels and Why do they Exist?
Support is a concentration of demand and resistance is a concentration of supply which are sufficient to stop and possibly reverse a trend. These are historical levels where a large number of shares traded in the past.
There are three different types of players active in the market. Those who are long, those who are short, and those who are do not have positions but are watching and waiting for an opportunity.
So, say a stock trades a considerable amount of volume right at the $20 for one month. This is how a sideways market is traditionally explained. As viewed on a chart this would be a perfectly horizontal line which extends for a month. In the real-world stocks never stay at such a precise level for so long but this is just a hypothetical example.
Then suppose the stock goes to $21. Those who bought the stock are happy that they are correct but they are angry they didn’t buy more. They say to themselves that if it comes back to $20 they will buy more. Conversely those who shorted it at $20 are angry that they are in a losing position and say to themselves that if the stock comes back to $20 they will cover their positions and break even. The third group is those who are watching. These could be traders who saw that the stock spent a lot of time at the $20 level, so when it moves away they are watching to see if it sells off. They buy it when it comes back to $20 because they think that the other buyers we discussed will be there as well. If there are other buyers, the traders consider this a low risk buy…meaning that if they change their minds and don’t think they are right they can turn around and sell it to one of them at $20 so they won’t lose any money.
So now we see why $20 will become a support level. It is because there is a large vested buy interest or demand for the stock at that price. Because this example is of a neutral or sideways market, meaning that the forces of supply and demand are roughly equal, the sellers will eventually push it back down from $21 to $20. If it was a Bull market those who were at $20 wouldn’t mind paying a slightly higher price and this is what causes Bullish Markets or Uptrends. More on that later.
When you understand these dynamics, it is easy to understand how levels that were support become resistance, and levels that were resistance become support. Suppose that our hypothetical stock trades below $20 and drops to $19. This would happen if the market went from neutral to a more Bearish Stance. More people were willing to sell at $20 than there were to buy. And because they are now bearish, some sellers are willing to accept prices below $20 because they believe that markets will continue to go lower.
So now the dynamics have reversed. Those who bought at $20 and were happy that it went to $21, are now upset and mad at themselves for not selling it and taking their profit. Now they have a loss, but they vow to themselves that if it rallies and gets back to $20, they will sell it so they can get out at breakeven. And those who shorted it at $20 are happy and say to themselves that if it gets back to $20 then will short more. So now we have a large amount of supply and sell interest at the $20 level.
What are Trends and Why they form...
Even someone with no experience in the markets can see that prices clearly move in trends if they look at a simple price chart. Prices do not jump around in a random way. When viewed on a chart which displays prices has time progresses it is easy to see that prices can move in three possible ways. They can move up or down, and if prices stay the same when viewed on a chart they will move sideways or horizontally.
One thing that is certain is that sooner or later the trend will change, and at these times profitable trades can be entered and exited. The key is having the patience to wait. Beginner traders feel as though they need to be actively trading every day. But in reality, there might be 3 or 4 obvious trades in a sector in a year. Not being too active and being out of the markets prevents overtrading and getting whipsawed.
Trend lines appear to be simple things but if you think about it closely they are dynamics graphical representations of the supply and demand dynamics is a given market. The fact that so many perfectly straight lines can be drawn is actually a fascinating phenomenon. Most take this for granted.
Now that you understand the concepts and dynamics that cause support and resistance levels to form, it is easy to understand how trends develop. They too are caused by supply and demand. Let’s think about a hypothetical example. Let’s say that the market is neutral. Most people think the markets are either rising or falling but a good amount of the time the markets are in equilibrium. This is known as ‘trading sideways’ or a ‘horizontal market.
50% are Bulls, and 50% are bears. Within these groups there are traders and investors who have different time frames. We can now understand how our hypothetical stock can fluctuate between $20 and $21. The buyers who have a longer-term bullish outlook but are currently neutral are content to stay at $20 and patiently accumulate what they feel will be a successful long-term investment. The sellers who have a longer-term bearish outlook but are currently neutral are happy to stay at $21 and sell at prices at the high end of the range before they decline.
In between these two levels…from 20.01 to 20.99 are different players that have shorter term times frames. The same dynamics we discussed with longer term investors are the same with shorter term…they are fractal in nature. For example, there could be day traders who are content to stay at $20.45 and $20.55. So in a hypothetically neutral market this could go on forever and prices will fluctuate between $20 and $21. This would be considered a ‘sideways’ or ‘horizontal’ market. The market can be considered 50% Bullish and 50% Bearish, which is neutral.
Now let us suppose that in our hypothetically perfect market for some reason 10% of the Bearish players become Bullish leaving 40% Bearish and 60% Bullish. Some of those who are Bullish still want to sell, but they will raise their price targets. This simple shift would break the neutral equilibrium and cause an uptrend. Now when XYZ sells off of $21 and closes back in on the important $20 support level, these now bullish investors decide that they don’t want to wait until prices fall all the way back to $20. Because they feel that prices are ultimately going higher they say to themselves that it makes sense to pay $20.05 because they don’t want to miss it.
Now crowd behavior and the herd mentality starts to kick in. The next time the stock rises back to $21 and sells off again, players will think that it rallied the last time, so it probably will again. Now they are willing to pay a little bit more…say $20.10 this time instead of $20.05 because they don't want to miss the next move upwards. And so on and so on and so… On properly drawn chart this phenomenon of mass psychology can be demonstrated with an uptrend line.
The same dynamics come into play in downtrends or Bear markets too...just on the opposite side. What is interesting, and is obvious by a simple look at a chart is that markets decline much faster that they rise. This is because markets sell off on fear while they rise on hope. Fear is a much stronger emotion than hope. This simple common-sense observation pretty much refutes most of what academia promotes. Markets are not efficient and they do not follow random walks.