- 1997: Volume 6, No. 4 International Corner: Tales From The Technical Trader: That Correction Is Out To Get You!

Has The Technical Trader succumbed to paranoia? Is this the final outpouring of an enfeebled mind? Perhaps, but if so it is also the obvious truth which comes from an examination of a market. A market is very similar to a machine in some of the ways in which it works. It may not have any moving parts as such, it may be spread over a very wide area as are its participants, but it is still a machine which has to obey certain rules. One of those rules concerns corrections but there are many others. Now the precise way in which the machine operates depends on how it is put together-as with all machines. Bicycles do not generally behave well when they leave the ground, helicopters do not work well under water. One of the simpler rules is that if there are more buyers than sellers, prices will rise and vice versa. Another obvious rule is that as prices rise it will encourage more buying because people can see who has benefited in the immediate past and they want to join that group. Another rule is that as prices rise it will encourage selling because there are those who may have missed out before at that price level and do not want to do so again, there are others who work on the basis of value and thus when price exceeds their perception of value they get out.. Ah! So now we have a bit of dichotomy; a price rise encourages both buying and selling-and of course a price fall has similarly diverse effects. Now you are beginning to understand something about market action-it is a balance between buyers and sellers all doing their own thing based on a large number of different perceptions, parameters, emotions and every other human input.

Now, what would happen if everyone thought the same thing? Let's say they all thought that prices were going higher. Well, first there would only be buyers-no one would sell. And if there were no sellers there would be no market. How could there be? If no one was selling what would there be to buy, and vice versa. So, in order to exist a market has to be a little confusing otherwise it would disappear up its own ticker tape. But does a market go out of its way to be confusing or is it just naturally that way? Clearly it is fairly natural for a market to be that way given the large number of people dealing in the market all for a vast array of different reasons. And we all know that markets are very often confusing. Now you know why. And there is no reason why many indicators should work at all. The only reason they may do so is on a statistical basis (i.e., they may measure extremes at which point the odds do favor their being right, but no more). As usual, the longer term the indicator, the more important its signals may be but also the less useful it will actually be in timing a trade.

Now it is easy to see what place a correction plays in keeping us all confused. It is easy to see how this process fits into the scheme of things. It is even easy to see why a correction must often break support or resistance to do its job right. But why does it happen that way? What compels such a move? That is a little more difficult, so let us examine the mechanics a little more closely. We will assume that the market has broken to all time highs-as FTSE and the S&P have been doing of late. Having seen a breakout to new highs it was difficult to be bearish. Having said that, there are always the Elliott diehards, among others, who are always looking to pick up new highs. But these people do not tend to represent an important force in the market because they are always getting wiped out. So at that point we can assume that the market has created something of a bullish consensus. But we also know that the futures and options markets-which are, of course, part of this machine-are a zero sum game. We know that the institutions tend to be net sellers of options and that any strong move is going to make their positions somewhat exposed. So they will have to hedge with futures. But then someone else has to stand on the other side of those futures positions. They will not want to, except at higher prices, so the price goes up even more. But the market cannot sustain unlimited bullishness. Indeed it cannot be sustained as at some point the reservoir of bullish money will become exhausted, and that is when a correction starts. Once it starts, it does tend to build its own momentum. Some traders see the high end come in and go short. Others see their profit drifting away and so decide to close out long positions.

Looking at the larger scale of things we can see that the correction will go on only as long as it takes to reverse the bullish consensus. The weapons available to the correction are very simple-they are price and time. Price is the most effective and a break of support or resistance is the obvious action required of the correction to do its job.

Another factor to be borne in mind is the various different time scales in the market. The correction may be in the short, medium or longer term. Incidentally, none of these terms has any absolute meaning but they have a relative meaning which is sufficient for the purposes of this feature. So we may say that over the medium and longer term nothing has changed. The market is still going higher. What this means is that a medium or longer term correction is not mandatory at that point, but a short-term one is because in the short-term there are too many bulls. But the correction will be all the more effective if it can shake out some of the longer term holders as well. But whenever it ends it will still be buying or selling opportunity all the while it continues.

Of course, some corrections will be over the medium and the longer term. These will of course be more dramatic and they will last longer and may take price that much further against the main trend-be it up or down. Some say that markets go sideways about 80 percent of the time. It would not be difficult to prove this if we were to analyze every market in smaller time scales and it is easy to see that markets will more often be in balance than not. But they move enough in the remaining 20 percent of the time and if you look at some recent charts you may think that most markets move up or down most of the time.

To summarize, the working of the market machine demands corrections and this can be likened to the internal combustion engine needing gasoline. Once the fuel of a move runs out, a correction comes in to replenish this supply. In market terms, the fuel runs out once too many bears have become bulls, or vice versa. Bulls and bears in this context means those who are long or short the market at that particular time. A correction then comes in to redress the balance and recreate the circumstances whereby the trend can continue-although sometimes the correction itself becomes the new trend. Unfortunately none of this makes dealing with a correction much easier but it is as well to know what is happening and why it is out to get you!

John Piper, FCA, ATII, MSTA, Hbt is the editor in chief of The Technical Trader. He is a resident of the UK where he runs the UK office of the publication. He can be reached at Sunflowers, Martineau Drive, Dorking, Surrey RH4 2PN. Telephone: 00-44-1306 882579. E-mail: john@ttttt.freeserve.co.uk.

For John's book go to www.the-way-to-trade.com/wayto/trade-197.php