The Handbook of Technical Analysis + Test Bank. Lim Mark Andrew

descending triangle may well precipitate a vigorous and rapid rally in prices due to the unexpected nature of such a move. Traders must exercise caution especially when shorting such a formation as prices can quickly explode to the upside, caused by an avalanche of short covering.

       Interpretational and Inferential Subjectivity

      This element of subjectivity with respect to interpretation and inference is not merely confined to applications in technical analysis. In fact, every form of analysis involves a certain amount of subjectivity and arbitrariness when it comes to its interpretation. For example, let us assume that the price of oil has risen significantly. This event in itself can be interpreted in two different ways. One fundamentalist may strongly believe that this rise in oil prices will impact the markets adversely as it will raise the underlying cost of commodities, whereas another fundamentalist may strongly believe that the rise in oil prices is a direct result of market demand, a bullish scenario indicating a healthy and growing economy. In another example, a technical analyst may strongly believe that an overbought oscillator reading is a clear indication that the trend is strong with further continuation expected in price, whereas another technical analyst may strongly believe that the overbought signal is a clear indication that the market may be already overextended and therefore expects a reversal in trend. The beginner quickly realizes, after some reflection, that for every bullish interpretation, there exists an equal and opposite bearish interpretation. This is one of the main reasons why forecasting is regarded as largely subjective.

       Subjectivity and Selective Perception

Human bias is another factor that adds to the degree of subjectivity when attempting to interpret technical signals. Chartists will many times ignore signals that conflict with their preconceived ideas of where the markets ought to be at any one time. They only select oscillators and indicator signals that support their analysis of the market. For example, a chartist uses three oscillators, the MACD, relative strength index (RSI), and stochastics. The chartist has a bullish view of the markets and believes that it is about to break to the upside. All of the oscillators have bullish readings except for stochastics. The chartist ignores the stochastics signal because it does not agree with his or her view of the markets. On a subsequent occasion, it is MACD that is not in agreement with the chartist’s view, and only the signals from the other two oscillators are heeded. This is known as selective perception. See Figure 1.19.

Figure 1.19 Selective Perception and Conflicting Oscillator Signals.

      Selective perception adds to the subjectivity of the forecast, as there is no fixed point of reference or basis for making decisions based on evidence. Choosing only signals that agree with one’s view will lead to biased and erroneous interpretations and unfounded forecasts. In fact, it is when there are discrepancies in the signals that the chartist gains the most information from the markets, as it may be an indication that there could well be some form of underlying weakness in the markets.

       Subjectivity in Determining an Event: The Point of Entry

Identifying, interpreting, and inferring market action are not the only areas where subjectivity plays a significant role. The determination of the exact points of entry to and exit from the market is also subjective at the most fundamental level of observation. What appears to be essentially objective is also built on a foundation of subjectivity. An example will help illustrate the point. Refer to Figure 1.20.

Figure 1.20 Example of Subjective Objectivity.

      Assume that a chartist is interested in identifying a market top via a trendline penetration. The chartist locates two significant troughs in an existing uptrend and draws a line connecting the two troughs, projecting that line into the future. Price eventually makes a top in the market and subsequently declines and penetrates the uptrend line, signifying the formation of a market top. This seems to be a totally objective exercise since the uptrend line and the point of penetration were clearly marked and recorded on the charts. Unfortunately, the objectivity ends here. Although each act of identifying the trend reversal was purely objective, the variables upon which the process of identification is based is determined subjectively by each chartist, according to their goals, biases, experience, and preferences. Another chartist could well have drawn a steeper trendline and declared that the penetration of this new trendline marks the true point of reversal in the market. As you can see, although each act of identifying the exact point of reversal is strictly objective in itself, the existence of alternative trendlines introduces an element of subjectivity as to which trendline penetration is the definitive indicator or signifier of the trend reversal. We can find another example of this subjective objectivity. Automated or program trading is usually regarded as a purely objective mode of trading where all the rules of engagement with the market are fully codified and mechanically executed. This removes all subjectivity with respect to the entries and exits. Just as in our previous example, the point of penetration of each trendline was also purely objective. However, should the automated trading software allow for some parameter adjustments, this instantly introduces an element of subjectivity as to which parameter adjustments are the definitive settings for a profitable trading campaign. Therefore, no matter how objective each individual act is, once the possibility of alternative acts exists, the issue of subjectivity arises. In a sense, each determination is individually objective, but collectively subjective.

      The very act of determining the exact entry point to initiate a trade is somewhat subjective. Let us assume that a trader is interested in initiating an entry at the break of an uptrend line. Price initially fails to exceed a previous peak, which is a bearish indication. Price subsequently declines and breaches the uptrend line, and in the process triggers a trade. Some questions that a trader may now ask are:

      • At which point after the breakout do I initiate an entry into the market?

      • What is a reasonable amount of price penetration required before an entry is initiated?

      • Do I wait for the penetration bar to close first or do I initiate an entry at some arbitrary point during an intraday violation of the trendline?

      • What if the penetration bar closes too far away from the original trendline breach?

      • How would I know if the violation is merely a false breakout?

      • Should I allow for a larger penetration before initiating an entry in order to filter out potential false breakouts? If so, how much larger a penetration is required to filter out such breakouts?

The answers to all of these questions really depend on the objectives of the trader and what he or she is attempting to achieve. There are essentially two ways of initiating an entry at the breakout of some price barrier. The first is to initiate an entry at some arbitrary point just after a breakout. The other is to initiate a trade based on some fixed rules of entry and exits. See Figure 1.21.

Figure 1.21 Subjectivity in the Rules of Engagement.

      Subjectivity arises not because the rules of engagement are unclear, but rather because of the number of choices available. Hence, each trader will select the rules of entry and exit that suit their personality, risk capacity, or familiarity with a certain mode of engagement. A trader could initiate a trade once price moves a certain distance away from the breakout, or once the penetration bar closes. Traders may even choose to enter the market after a certain amount of time has elapsed from a breakout. Figure 1.21 lists three main types of filters that traders frequently use to initiate an entry. Price, time, and algorithmic filters will be discussed in more detail in Chapter 5.

      Summarizing, even if the rules for identification, interpretation, and inference are rigidly codified, the very fact that we have choice renders the entire analysis subjective from the ground up. Hence the argument that