Trading Regime Analysis: The Probability of Volatility

By Murray Gunn
Copyright 2009 John Wiley & Sons Ltd.

Appendix 2
Why Do Trend Lines Work?

Trend lines traditionally connect a series of highs or a series of lows on a time series
price chart. Most people who come across technical analysis for the first time are
immediately drawn [sic] to trend lines because of their simplicity and subjectivity.
It is this simplicity in fact which makes trend lines some of the most valuable and
important tools in a technical analysts box. However, not many people stop to think
about and communicate the logic behind trend lines, and this encourages the critics
of technical analysis who would liken trend lines to mumbo jumbo, alchemy or
self-fulfilling prophecy!
Trend lines, in simple terms, show where supply and demand probably (not definitely) exist. In my opinion, therefore, they should be called supply and demand
lines because this more accurately reflects the logic behind them. Supply and demand
of the instrument in question drives the market price. Nothing else drives it. Not economic, technical or quantitative analysis. Not even economic or corporate statistics,
as virtually everyone in the modern markets is conditioned to thinking, and what
we spend most of our time talking about. It is, in fact, human beings that decide on
the clearing price for the market (the market price) by interacting and haggling with
each other. It is how human beings act and react to information or analysis, not the
information or analysis itself, that is the most important thing. How many times has
the market moved in the opposite direction after economic or corporate news to what
conventional logic would have us believe?
Surely it is the job of the market analyst to identify where supply and demand of
the instrument itself actually lies. Yet market analysts spend a lot of time analysing
and espousing about where they think supply and demand should lie based on something that may or may not be related to the instrument (e.g. the dollar should fall,
based on the current account deficit). This is where trend lines and technical analysis
in general have a purpose. Technical analysis aims to discover how bullish or bearish
the market is as a whole, not how bullish or bearish the analyst is. It can therefore be
said to be unbiased.

408

Trading Regime Analysis

Human beings have moods that swing. Our psychology is affected and shaped by
events that happen to us. Is there anyone who can refute this point? If this is right and
human beings decide what the clearing price of the market will be, it follows that the
clearing price of the market will swing around with our emotions. It is because of
this that the stock market is essentially a barometer of mass social psychology in a
society. When markets move around, the moods of the participants in those markets
are directly affected by the moving around of the current price. Anyone who refutes
this has obviously not traded or invested anything in their life! We feel fearful and
unhappy when the price is going against our position, and happiness and greedy
when it is going with our position. Therefore, when the price moves, the actions of
human beings will be dictated by the position they have and which way the price
is going.
Take an example of an up move in price. If the market starts a move higher, those
people who are long will feel happy but those short will feel unhappy. The market
will move up until there are no more buyers and/or when the feeling of booking
their profits overwhelms some of the longs. The market will then start to move lower
and retrace some of the up move. How much retracement takes place depends on
how much emotion is around by the market players. The people who are short and
have just witnessed a move up will be relieved to see the price coming back down.
Their emotions will be driving them to get out of the short position and they will
buy back their shorts. Also, those that were flat when the market started to move up
will be keen not to miss out if a bigger up move takes place and will be looking to
establish long positions on this pull back in the price. In this way the market fall has
created demand that has been driven by human emotions. If this process repeats a
couple of times, the market has an uptrend. In fact, this emotional process starts to
feed on itself. This is the real self-fulfilling prophecy in the markets but it is being
driven by natural human psychology whichever brand of market analysis the market
players are following, and not by one group of technical analysts! As a bigger move
up happens, the people who are short are now even more fearful while the people
who do not have a long position are even keener to establish one. So, again, when
the price moves back down a little as buyers have run out and/or longs are booking
their profits, the retracement in price is met with demand from people feeling relief
(shorts) and greed (fresh longs).
As the market repeats this psychological process a series of higher highs and
higher lows occur. All a trend line is doing by connecting the series of higher lows
is identifying the strength (or the pace) of the psychological process. The strength
and direction of the psychological process will dynamically change of course, and
this is why trend lines will be broken and invalidated more often than not. However,
a simple trend line is a very powerful and essential tool in identifying the direction
and strength of the emotions of the market players.
Critics often attack the clear subjectivity in drawing trend lines. In my opinion,
the analysts should not get too bothered about how precise trend lines should be.
The markets are driven by psychology and psychology is, like economics, a social

Appendix 2: Why Do Trend Lines Work?

409

science, not a hard science! The analysts should think of zones rather than precise
levels when identifying potential support and resistance areas via trend lines. A good
analogy is to think of drawing trend lines with a thick pencil. This allows for what
some call internal trend lines where, in the example of an uptrend, the price might
dip just below a trend line drawn with a sharp pencil but a thicker pencil would still
have captured the low price! These, what at first glance look like failed trend line
breaks when drawn with a thin pencil, often provide the strongest of signals because
of the fact that the market has possibly taken out some standing orders (like stoplosses), but then realised that there is no more buying (in the case of an downtrend
break) or selling (in the case of an uptrend break) to be done by anyone. By the
economic law of supply and demand, the market has then to reverse and go back into
the trend. Remember, all we are doing is identifying that a retracement in the trend
has resulted in an emotional process by the market participants that manifests itself
in (for an uptrend) a series of higher highs and higher lows. The best way to think of
internal trend lines is as drawing a buffer zone around a trend line that takes account
of general zones where supply or demand probably exist.
Lastly, think about this. If trend lines and technical analysis is a self-fulfilling
prophecy, as some claim, how is it that trends can last for years when, if all the technical analysts in the world acted at the same time, that particular supply or demand
would be absorbed into the market price very quickly?
Trend lines (or supply and demand lines) are not magic, mumbo jumbo or
alchemy. The analysis is rooted in human psychology and crowd dynamics. It is the
behavioural characteristics of human psychology that determine the clearing price
of the market and trend lines are useful in helping to identify areas where these
behavioural characteristics might occur.