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A Share Trader with a Theory

We have a share trader in the house with a theory. It’s a theory about price action and how many, many followers of technical patterns get wrong-footed at important turning points.

Over the past decade or so, we’ve noticed that charting, or technical analysis, has become much more popular. That’s probably because of the perception that it’s much easier to make money from responding to squiggles on a chart than doing the hard years of analysing a balance sheet and cashflow statement.

But the more popular something becomes, the more you have to worry about it not doing what you think it’s going to do. Because when everyone’s looking at the same thing, you can bet that the opportunity to make a profit from that ‘thing’ has long since disappeared.

Recognising this, our share trader developed a theory. It’s a theory that we’re not sure anyone else follows. And if no one knows about it, then the ability to profit from this theory of price action still exists, because no one else has worked it out to arbitrage the opportunity away.

The share trading theory is a good one because it’s simple. And one simple tenet of the theory is that people are mostly lazy and respond to signals that turn out to be false. The signals turn out to be false because they’re largely brought about by everyone looking for and responding to the signal in the first place!

Our share trader reckons this herd like behaviour at important turning points provides an opportunity to make big profits from taking the other side of the trade from the ‘crowd’. And before long, the crowd recognises its mistake and rushes back to the other side.

Without giving too much away, here’s a recent example of the crowd maybe getting it wrong. They haven’t recognised it yet. But when they do, look out…

Below is a chart of the ASX200. As you can see the 5,000 point level is an important one. It didn’t break above that point in 2010, 2011, or 2012. But it finally did in February 2013. It got everyone excited and once breached, share traders who look for these things jumped on board.

 

But the momentum from that important break above 5,000 didn’t last long. In fact, the index turned down pretty quickly. It’s now resting right around the 5,000 mark, an important juncture for the bulls and the bears.

Our share trader reckons this could be a classic false break. He’s seen it happen time and time again, which is why his theory, unlike, say Keynesianism or monetarism, works well in practice too.

We’ll have more on this theory soon…stay tuned.

In the meantime, buy gold and sell paper. When Bernanke says he doesn’t yet see a problem, it’s time to take out some cheap insurance if you haven’t already done so.

Regards,
Greg Canavan
for The Daily Reckoning Australia

Join me on Google+

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Greg Canavan
Greg Canavan is a feature editor of The Daily Reckoning and is the foremost authority for retail investors on value investing in Australia. He is a former head of Australasian Research for an Australian asset-management group and has been a regular guest on CNBC, Sky Business’s The Perrett Report and Lateline Business. Greg is also the editor of Sound Money. Sound Investments, an investment publication designed to help investors profit from companies and stocks that are undervalued on the market. To follow Greg's financial world view more closely you can subscribe to The Daily Reckoning for free here. If you’re already a Daily Reckoning subscriber, then we recommend you also join him on Google+. It's where he shares investment research, commentary and ideas that he can't always fit into his regular Daily Reckoning emails.

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