I get a lot of flack for this, but Al Brooks and other writers of chart analysis don’t really know what they’re talking about.
Stock prices and chart patterns you see are the result of lit crossed orders and do not tell you the intention of the trades (remember for every seller there is a buyer) on each candle. Brooks has never worked or studied with market makers or institutional traders, also he rehashes the “common” thinking of retail traders without doing any study.
Some key concepts that serves as the basis of his thinking that’s wrong are:
- There is intention behind every candle/tick — this is patently false, I’ll explain below
- Trading is not zero sum — he’s confusing trading with investing, trading is zero sum (actually slightly negative skew due to paying for bid/ask), investing isn’t
- The guys on CNBC know what they’re talking about — 90% false, most of CNBC is garbage (same goes for Bloomberg unfortunately)
In the real world, trading has become very fragmented. Most larger investors cannot facilitate their trades across just one venue, and absolutely are not trading by tick or candle. This is because of the disintermediation trend (banks are no longer the major market makers in equities, regulation also drove this), the rise of alternative trading networks (dark pools and other exchanges, lit or dark), and the role of hft firms (as market makers and speculators).
When you think about trading, you should first seek to understand it as being an exchange that facilitates the logistics of investing. ABC fund wants to buy XYZ stock, and they submit an order to the exchange (or source of whoever may have the shares). That order can take time to fill — from seconds to hours to weeks.
The intention to buy is driven typically by an analysis of the growth or value prospects of the stock (most fund investors rely primarily on equity research, internal or otherwise, to develop a view on a stock). From there, the fund will usually start a position (if it’s a billion dollar fund then even 1% is still $10MM in value) and will usually set a max weight of 5-10% of the portfolio in any one name.
To start a position the fund’s trader will first look at displayed liquidity to gauge what the transaction cost might look like. Transaction cost is primarily the slippage — the amount the shares move as you are trying to fill the order.
If you look at the bid ask of any stock you’ll see price x size. So when you, as a larger trader, try to buy, you are lifting the ask x size. If the displayed size is 1k and your order is 10k, you will easily take the nbbo’s offer, and start to get worse prices.
Imagine you’re on Amazon and are trying to buy a book, and sort it by price. The size at best price might 1-5 copies— so if you buy 100 copies the price will get worse for you.
Because of this challenge, traders mainly fill their orders using algos that seek liquidity or that manage the size of the order as a % of volume in order to hide what’s going on. If you overlay all these different approaches, you begin to realize that at a very short time scale, the trends will look random but that as you “zoom out”, trends in price and volumes are correlated. What this also means is that you have no edge in shorter time frames (unless you are the guy dumping or buying stock in size). On the chart, the price will oscillate wildly.
Once you begin to add on the normal volumes of the stock, you get a noticeable, incremental trend. Because large investors can take days/weeks to fill orders (and because there are lots of them moving in and out of stocks), you get momentum in both the short and medium term. For example, 5-day momentum typically reverses in the subsequent week as does 20-day momentum (at the margin more funds were buying/selling and it takes them that long to trade).
With that being said there are possible trades you can make using charts:
- Momentum is a good one, simply if price has risen over the last 6-12 months (in absolute and relative to local index), it tends to persist
- In the short run momentum reverses (5 and 20 day), there is possible intraday momentum but there is actually a negative drift during trading days for most stocks
- Market anomalies such as price spreads between companies doing a merger/acquisition when one stock moves, small cap anomaly due to funds seeking liquidity at the end of day, slow diffusion of information anomaly where large cap stocks are more efficient than small cap so you can trade the small cap on large cap news, etc. but these all require more work to figure out the anomaly and how to harvest the returns from it
Tl;dr
Al Brooks never worked on a trading floor, nor has he apparently ever spoken to someone who has, so his understanding of how trading works is factually incorrect. I would avoid reading his books or spending time trying to figure out “price action” at this level. I’d recommend that you pick up a basic book on corporate finance first to understand how managers of companies buy/sell/issue stock and debt, read a book on market microstructure to understand the logistical considerations (different exchanges and ATNs and how it all consolidates on the chart making the chart super noisy), and read about the investment process of institutional investors (can read books written by them or training material for their jr staff).
Once you have the foundation you should then start reading leading papers on major anomalies you’ve heard of such as the momentum, value, and size factors. From there you’ll be able to learn about various anomalies or discrepancies and can then do your own research to see if there is an opportunity. This is the path of successful traders.
