Learning to Read
Trying to predict what the stock market will do is for dumbasses. A proper analysis of the big name stock tippers and analysts shows that they are all significantly worse than random.
This is a spreadsheet built by Tim Knight tracking Gartman’s predictions, running at a 22% correct rate for the year. What Tim fails to mention is that his own predictions are every bit as bad.
Predicting markets sucks, and it induces a whole bunch of mental baggage where we make a prediction and all of a sudden want it to be true. We cheer it on like a horse at the track.
There is a bug in our mental wiring where we only remember the correct calls and cannot remember the losers. A prediction monkey can be right one in 4 times and all we can remember is that one big win. This is a very tempting way to trade, but that way lies ruin. In the strongest possible terms I tell traders to walk away from every method that claims to be able to predict the future with unerring accuracy (wave theory extra fuck you).
But even so, there is still a lot of information contained in the way price unfolds. Our job as traders is to interpret the constant stream of information objectively in the now moment, trading only when the odds are in our favour.
We wait, for those times when either the bears or the bulls have fucked it up, and will have to pay the price for their folly. We then join the winning side and help kick the hopeless bears (or bulls, I’m an equal opportunity savage) into a puddle of lovely red strawberry jam.
People often ask me for an explanation of reading market price action. I’m going to give a basic overview today, and we will dive deep on some specialty topics over the coming weeks. Beginners make too much out of this skill. In the final analysis it is cool, but not as relevant as you think to trading success. It’s really just a cool trick, honestly, and some of the best traders I know cannot do it at all. If you were deciding to spend time learning this or the system building material I will cover, it’s a no brainer. Systems > tape reading, every time.
There is a couple of fundamental points I need to make.
Every single bar of price action gives us fresh information in context of what should be happening. It either confirms or casts doubt upon the most likely theme, or provides clarity towards a resolution. Nothing is irrelevant, nothing at all. If it *should* be going down and it didn’t, that is important. If it could not close below a previous low, thats important. If the range was decreasing as the trend went on, that’s important.
Big money controls the market. The big banks and hedge funds win every single time. If we want to be profitable we should be doing like they are doing, and fortunately for us, big money leaves big footprints. We walk along behind, seeing the footprints in the sand, working out what the big money is doing and we do the same.
To read the tape, we slow it down, and go through every bar one at a time, reading out the story that price is telling us. We want to get away from the idea that we know what the future brings, and treat it like an interesting novel, each page brings us more information and we can’t wait to see what happens. Any preconceptions we might have just ruin the story.
Let’s break it down. The very first thing you want to do when you look at a chart is say “Is it a trend or a trading range?” And the kicker is that if you don’t know, or there is any doubt at all, its probably a trading range.
- Very few overlapping bars
- Strong kickoffs
- At the start they have small pullbacks or pullbacks contained within a single bar, indicating that the bus leaves empty
- Bars where the price action opens at or near the lows, and closes at or near the highs, and vice versa
- Sequences of several up bars or several down bars in a row
- Pullbacks in trends are choppy and the ease of movement is with trend direction
Trading Ranges have:
- Lots of overlapping bars
- Price action that looks like random, where you get an up bar, then a down bar, then another up bar, etc
- Lots of doji bars, small range bars that close somewhere in the middle
Now in a trend the optimal thing to do is to buy pullbacks and hold for an extended move. In a trading range the optimal thing to do is to buy at the bottom of the range and short at the top, and not hold for very long, just scalp a quick bit of cash and jump out.
These two approaches are opposite, so it’s critical we figure out which one is in play.
Ok, got that. Trend or trading range is critical. Good. If you only take one thing home today that’s the thing.
Now, moving on. One bar at a time. Get all your stupid indicators off the chart, they don’t mean a thing anyway. They don’t have predictive value, price doesn’t “find support at the 50 EMA” its just a line on a chart that’s a derivative of price.
Zoom that chart all the way in. You only want to be looking at a few bars at a time.
Each bar you want to be looking at
- Did the bar break a previous bar’s high or low?
- How close to the top and the bottom of the bar did the bar open and close. An open at the lows close at the highs indicates buyers controlled both the open and the close (ie sellers are fucked)
- Did the bar close above the previous bar’s high or low?
- Was the range increasing or decreasing?
- Is there a microgap (open above the previous close)?
- How much overlap is there with the previous bar (overlap is two sided price action)
- What will bears be hoping? Is the bear case still viable?
- What will bulls be hoping for? Is the bull case still viable?
- What SHOULD have been happening this bar? Did that actually happen, or did something weird happen indicating that something else is in play?
See how much more detail I go into on every single bar than most of you? Every single bar you want to do this much analysis. I literally read it out in my head like a bedtime story.
Let’s observe the breakout in the ES futures from the trading range, bar by bar.
Look at the most recent bar above, closely. See the tiny gap, at the open above the previous close. That right there is a telling clue, that the buying pressure was so strong, that traders could not and would not wait to get long, they just bought the bid right at the open, they were so bullish that they didn’t care they were bidding the price up. Small thing, big clue!
At this point most of the bears would have been forced to cover. The few remaining shorts would be hoping against hope for a failed breakout, but that is an extremely low probability outcome. The bears have only a limited amount of ammunition before they become weak for a time. If they expend selling pressure here, they will be unable to mount an effective defence later on. So we should eagerly watch for any signs of selling pressure. A failed attempt to drive the market down here would be extremely bullish. And a successful attempt would be a low probability outcome, which usually results in a big move. We just don’t know yet, we only know that the odds strongly favour a bull move at this point, and only the dumbest of traders would remain short.
You don’t read the tape to try and predict the future. At any given point you kind of know the odds of it going up or down. The best betting odds you get are rarely better than 65:35. A significant amount of the time the odds of it going up or down are truly 50/50.
But here’s the catch. Low probability outcomes cause MASSIVE MOVES.
This is so important I’m going to repeat it, a different way. When something looks really really certain to happen, and it doesn’t, then almost certainly the market is sending a hidden signal it wants to do the opposite. When traders get positioned short on a very obvious short setup, and that short setup fails, they will be forced to cover, driving prices higher.
Let’s take a look at the worst time in the GFC to illustrate this. What I want you to see is the last red bar 5th from the right. That bar, the market tried to go up, failed, and closed at the lows of the month, indicating the sellers were in control. It also closed below the previous 10 year lows, with an increased range, indicating things are accelerating to the downside and there is no buying pressure in sight. At this point it’s reasonable to assume that the market is completely and utterly fucked.
Now at the furthest bar on the right hand side of the chart we have a 4 bar counter trend rally. Each bar is decreasing in range, indicating the rally is gradually running out of steam. The last bar has about 60% overlap with the previous bar, indicating two sided price action, and the last bar closed below the previous high, indicating the market could not support fresh highs. Also it’s a shooting star, which is a nice way of saying the market tried and failed to go up in a single bar. All in all we have everything looking bearish as fuck, from every perspective you can think of.
Or is it?
Let’s put our thinking caps on and go back to the lows. The market SHOULD have gone down after the last red bar. Why didn’t it? Our spidey sense should be tingling there. It’s a clue, a big clue, and we have to remember that every single bar of price action gives us fresh information. Nothing is useless.
Even so, the market objectively would be a 70% chance of at least attempting to go down and retest the lows, the whole world would be getting short again, preparing for another leg down.
What happens when a high probability outcome does not happen? Low probability outcomes cause MASSIVE MOVES, memba?
As for the markets today. The big news is Crude broke out of it’s months long trading range. The easy meat is done, expect a bit of chop today and don’t rush in. But no longs in CL, the market has spoken, and you don’t wipe away one of the longest trading ranges in history with a single day move. As for the indexes, the market tried and failed to go up today, when it was reasonable to assume another assault on the old highs is a probability. The conclusion is that bears are a little stronger or bulls are a little weaker than they appear, but price action is still very two sided. This is a market balanced on a knife edge, and we don’t have betting odds. The highest probability is for a long setup appearing after a more complex and hard to figure out correction.
We will resume the system building stuff tomorrow. Scott