The Humans Behind the Candles

Markets, a place where people buy, sell, and trade goods and commodities, probably makes you think of a scene in a medieval town where a farmer sells his apples for coin to a mysterious traveler from a faraway land. A transaction where both parties can see and feel the product, and look each other eye-to-eye as the apple and coin switches hands. A moment where the traveler does not catch the apple merchant's subtle, devious smirk. Little did the traveler know that the apple merchant had taken advantage of his ignorance and doubled the price.

After the transaction, the apple merchant catches an old man's look of disappointment from across the market. The old man sells oranges, which have recently gone out of fashion for apples. The apple merchant shrugs his shoulders, business is business.

Two months later, half the town find themselves with severe stomach problems and word spreads that it is the apples. The mob finds the farmer at his stall and demands compensation.

"Give me back my 2 bronze coins or I'll burn your house down!"

"2 bronze coins!? I bought an apple from him for 3! This man is not only a murderer but a liar as well!"

"He charged me 5 coins for two apples!" An accusatory finger points, "My kids are sick and you are to blame!"

The apple merchant had no where to go. He surrendered to the crowd, giving them all he had.

Two weeks later, the town is back to normal and the marketplace is running as usual. Except one thing, no one is visiting the apple merchant's stall. After the whole fiasco, he put up a sign with the price of an apple. The sign read "2 bronze coins" per apple, but since reopening his store, it has gone down to 1 copper coin. The apple merchant slouches in his chair, defeated.

The old man sells some oranges here and there. The old man hands a few oranges to a woman and receives his coins, wishing her a good day. He catches the farmer's eyes, and shrugs his shoulders.

Financial Markets and Rationality

While a local produce market may differ fundamentally to a financial market, the sentiment of the story above is still valid. Markets react emotionally. Financial markets in particular are susceptible to emotion because they are inherently speculative. Compared to when you buy an apple, buying a share of AAPL requires you to make a long-term commitment. In addition, it requires you to make a prediction.

Predictions are dangerous because they make us play the role of God. We have to suspend our belief that we can only know the present and the past, and include the future. Where was AAPL two years ago, where is it today, and where will it be two years from now? If we predict that AAPL will go up 50% in the next two years and it does, we will feel like prophets. If it instead goes down 50%, we will feel like fools. Either way, no one can ever predict with accuracy where financial markets will go because there are simply too many factors at play and because financial markets are deeply irrational.

The rational market would only go up in the long term, and there would be systematic buying and selling to ensure healthy profit taking. Investors would hold for the long term and grow the pie. Everyone would benefit. But in reality, markets are irrational and act in ways that may even be detrimental. Excess fear and excess greed manifest themselves in options trading and leveraged positions, leading to unnaturally large corrections and surges. Traders delude themselves in thinking that they can time the markets perfectly. The young are too arrogant and take on too much risk, and the elderly are too afraid and take on too little. Emotion is definitely behind much of price movements, so why is it difficult to imagine it exists?

The Abstraction of Emotion in Modern Day Financial Markets

Modern day financial markets are very abstract. We can buy and sell assets and equities with a click of a button. We have no idea who we've sold to or why they've bought. We have no connection to the other side and there is no conversation to be had. Of course, we can boil it down to two things: you sold because you no longer think it is a good investment and they bought because they think it is a good investment. It's easy to imagine robotic hedge fund managers wearing perfectly fitted suits sitting with optimal posture at their desks executing only the most rational trades and investments worth millions. But aren't they human too? Don't they have biases, deadlines, personal battles, dreams, and fears?

I'll say it again: financial markets are very emotional. The two primary emotions that drive price fluctuations are fear and greed. Fear makes people capitulate and sell. Greed makes people FOMO in and buy. Each investor/trader has their own reasons to act and have their own outlooks on what certain externalities mean for their own positions. But we never really get a taste of it. We don't see the working man run into the marketplace with fear in his eyes, frantically trying to sell his positions because he needs to pay off a mortgage. We don't see the youngster who confidently strolls in, betting what little savings he has on the "next thing" even though it has already doubled in the past year. And we definitely don't see the hedge fund manager scrambling to meet his ROI goals before the quarter ends. Every trade has a story.

When you add up every story, you get market sentiment. What are the most common things we tell ourselves about the market? What hopes and dreams does it provide us? What safety does it ensure? In order to read the story of a market, we need to know basic technical analysis.

Technical Analysis Allows Us to Read the Emotions of the Masses

Let's take a look at the most recent price chart of the QQQ, which is an exchange-traded fund (ETF) for the NASDAQ market. An ETF basically allows an investor to invest in a collection of stocks. Investing in the QQQ is the closest thing we can do to investing in the entire NASDAQ market.

The chart is read from left to right, with time on the x-axis and price in USD on the y-axis. At the time of writing this, the price of QQQ is currently around $336. Each little "candle" is the price action of a day, as we are looking at the chart on the daily time frame. Green candles are where the day ended higher than it started, and red candles are where the day ended lower than it started. Where do you think the price goes from here in the next few months? Just take a stab at it, draw an imaginary line with your finger. No seriously, go ahead.

...

How did it feel to make that decision? If you have done technical analysis before, there was probably some thought put into it. But if you haven't, it may have felt very arbitrary. Now what if I told you that you have put 50% of your savings into the QQQ? Where would your mind instinctively want the price to go? Up, of course. Now what if you've been wanting to get into the QQQ but you think you can get it at a cheaper price in a month or so? You'd want it to go down. To put it simply, as soon as we decide on what to do, we are biased towards a certain outcome. However, markets don't care about our biases, nor do they care about our plans. They only care about our actions.

Action is what drives price up or down. If more people are selling than buying, the price goes down to meet market demands. If more people are buying than selling, the price goes up to meet market demands. This is true because for each trade, there is an agreed price between the seller and buyer. When there are more sellers than buyers, the buyers have more say at what price they'd like to buy at. This is because buyers are low in supply, but high in demand. Of course, buyers would want to buy as cheap as possible. This is also true for the inverse. When there are more buyers than sellers, the sellers have more say at what price they'd like to sell at. This is because sellers are low in supply, but high in demand.

So if action is what drives price changes, what does emotion have to do with this? Emotion drives action. If we can get a read on someone's emotions, we can get a better sense of what they will do next. For example, if we could watch the hedge fund manager, John, do everything he did for his entire life and could tell what emotion John was feeling at any given moment, we'd get pretty good at predicting what he'd do next. We won't be able to predict everything and we won't be too precise, but the probability of our prediction being correct would increase. John got cut off in traffic and is angry? Well the past 5/6 times this happened he honked his horn and flipped the other driver off. What do we think he'll do this time?

It is important to note that if we don't know how John is feeling, it becomes much harder to predict what he will do. He may be in the same exact situation where he gets cut off, but perhaps he feels elated. Would he do the same actions as when he was angry? This is what makes financial markets especially tricky. We may encounter similar macroeconomic situations as in the past, but if the market feels differently about it, we wont see similar price action.

Technical analysis allows us to tap into market sentiment. To give a brief definition, it is using chart patterns and price action to aid in investments and trading. Let's take another look at the QQQ price chart, but with lines drawn in.

I've drawn in two channels showcasing a trend reversal, an up trend in white and a down trend in red. We can see that the price from around September to December 2021 trended upwards in a systematic fashion. Once it hit the top line it usually fell back down to the bottom, and vice versa. All that these lines are telling us is that buyers are coming in at higher prices than before, and sellers are selling at higher prices. That generally indicates that investors are hopeful, i.e. they believe that things will continue trending up with time. This can be labelled as a healthy market. Of course, illness spares no one.

As you can see, this channel broke in January 2022, which can be inferred by the price breaking the lower trendline of the white channel. This trend reversal was confirmed by the price breaking below $350, where buyers previously stepped in to buy in mid-September (the gold horizontal line). This is called a lower-low. Buyers are no longer buying at prices they used to. Furthermore, sellers are no longer waiting for higher prices to sell at. This is called a lower-high. We saw a sharp sell impulse at around $370 in early February, but we've seen sellers willing to sell at $380 back in early September. We are now in the red downward channel until we see this pattern breaking. With a lower-low and a lower-high, behavior has changed. Why? Because sentiment has changed.

If we take a look closer at the green box, we can see increased volatility. Volatility is a sign of uncertainty and increased emotions. People are buying more than they usually do, and they are also selling more. The volatility failed to break into higher prices, and so it broke into lower prices. It was a battle between greed and fear, and the fear won over. We can look into the news and see what caused the fear, and we may find the Russia/Ukraine political unrest, or the Canadian trucker revolts, or the Fed starting quantitative tightening, but these events could have been ignored by investors as well, just as John could've ignored being cut off in traffic. Because the masses have reacted to these news events with fear, price has fallen.

The fear does not stop there however. The initial drops in price may be connected to news events, but the fear builds surrounding how far the drop could go. Is this The Big One that we've all known was bound to happen but deluded ourselves that it wouldn't? We humans are weak in the face of fear, and we act irrationally. We instantly imagine that we are going to be the victims of the greatest crash in history. The U.S. financial markets will crumble right in front of our eyes. There is almost a devilish longing for it, like how we sometimes imagine what the end of the world would look like. All of this leads to a capitulation event, where all the fearful selling happens all at once, like the body vomiting out a bad apple.

When the dust settles, and all that is left are the people who stayed in control of their emotions, there is no more fear. No more selling to be had. This new beginning creates a solid foundation for healthy markets to resume once more. And the markets will resume, no matter how difficult it is to imagine. Just take a look at the major crashes in the history of QQQ (in log scale for ease of viewing).

Technical Analysis Allows Us to Read Our Own Emotions

With technical analysis, we can also get a better sense of what the market tells us about ourselves. When we first look at a chart, what are key levels your eyes are drawn to? What candles do we see that are not really there? What trendlines do you use to determine a reversal or continuation? What moving averages do you use to determine support and resistances? All of these are at the analysts discretion.

Pure fundamentalists would argue that technical analysis is bogus because it is too subjective-- it's just reading tea leaves. While it is true that technical analysis is subjective, it is akin to ethical debate in that there are still strong and weak arguments. When a trendline has shown to be respected or when a moving average has consistently proven to be a good buying level, that can be considered as a "strong argument".

With this framework we can become cognizant of times where, despite the arguments strongly favoring against us, we arrogantly hold onto losing positions. Despite the truth unfolding in front of our very eyes, we sometimes project different candles onto our screens. That is, until we are faced with reality, finding ourselves deep in the red one morning and urgently needing cash.

Furthermore, how we draw on our charts exposes how we think of the future. Do we think the end is right around the corner? Do we think that we will go on an extremely bullish run and double our money yet again? How desperate are we when we draw our lines? How patient are we? When is a good entry? Have we even thought of an exit? Are we predicting or are we assessing probabilities? It is all laid bare on the charts, but similar to debating arguments, we can only notice our biases when we read other people's charts. After all, we are just one of the many stories that create the market. We are just one of many humans behind the candles.