Open your charting platform to an instrument that you normally trade. Look at the last candlestick. Now look at the previous candlesticks that have led to that last one. Do you think the next one will close higher or lower than the current one? How about the one after? If you use any analytical tools what are they telling you? Do you have an idea where the next few candles will take the price of this asset?
Perhaps your various methods of analysis, be they technical indicators, trend lines or candlestick patterns, are telling you something about how high or low the current price is relative to recent price action. Maybe this information provides you with an insight as to what is likely to happen to the price in the next minutes/hours/days. Now try zooming out, or viewing the chart at a longer time frame. Does your theory still hold, or do things start to look different once you have more of the asset's history up on the screen. Perhaps charting at a longer time frame has put the movements you were monitoring at the shorter time frame into context. Maybe now you see that the asset has been way lower in the past so what you previously thought of as a point of resistance just isn't so.
Trading, for all intents and purposes, is like standing somewhere on a mountain range with a blindfold on. Your feet are telling you how steep the terrain is around you, but you have no conception of how low down or high up you currently are in relation to the path that lies ahead. Imagine there is only one path forward, even if you personally took every step on every ridge up to the point where you currently find yourself (and so have some idea of how low you have been and how high you have come), you still have no way of knowing whether your next step will lead to an exhilarating uphill climb to the summit, or down a ravine to your certain death.
Now imagine taking the blindfold off. If you could actually see the path ahead, how much time do you think you would spend looking at the steps you've already taken to get there, rather than at the challenges that await you? See, this is the real trouble with trading, the path ahead has yet to be laid. We live it's creation minute by minute, our fortunes are made and lost in this indeterminacy and that's precisely what causes us to clutch at any certainty, any hint of determinism.
This is why historical charts are so compelling, because when you look at something that has already taken place, it is always going to seem deterministic. On a price chart the way things unfolded are right there for all to see. The price level went from a to b to c in what looks like a logical set of steps that we can then try to explain and theorise with the benefit of hindsight. Surely the price drop at b occurred because such and such piece of news was released at roughly the same time and spooked traders. And the spike at c, well that's probably because so and so came out in the media with a positive statement that brought confidence back to the market.
The same goes for chart patterns. It's easy to come up with what you think are rules governing the way an asset's price moves by looking at candlestick shapes and applying technical indicators to historical price action. The problem is that these rules only hold true until the present moment, and more often than not price action will violate the rules you have based your trading strategy on. It's easy to come up with a theory using hindsight, try doing the same thing with the current candle as you were asked to at the beginning of this article and it's not quite as clear is it?
In his book The New Market Wizards: Conversations with America's Top Traders, Jack D. Schwager asks mathematician/floor trader Willian Eckhardt why he believes that 98% of things that look good on a chart don't work in reality. His response is intriguing:
'The human mind was made to create patterns. It will see patterns in random data. A turn-of-the-century statistics book put it this way: "Too fine an eye for pattern will find it anywhere". In other words, you're going to see more on the chart than is truly there. Also, we don't look at data neutrally, that is, when the human eye scans a chart, it doesn't give all the data points equal weight. Instead, it will tend to focus on certain outstanding cases, and we tend to form our opinions on the basis of these special cases. It's human nature to pick out the stunning successes of a method and to overlook the day-in, day-out losses that grind you down to the bone. Thus, even a fairly careful perusal of the charts is prone to leave the researcher with the idea that the system is a lot better than it really is.'
You see, the candles you looked back on in order to decide where the price is likely to go, the technical indicators and trend lines that you may or may not have applied to your chart, the price that you currently see on your screen, all of these things refer to events that took place in the past. Your indicators are drawn using a combination of past price data and certain mathematical functions, the candles you see refer to price action that took place during specific intervals of time, even the current price on your screen refers to a level that will no longer be valid in any second as new trades are confirmed at different prices.
That's not to say that price charts and technical indicators aren't useful. It's just that being overly reliant on them can give you a false sense of your own predictive abilities. One of the best ways to prove this to yourself is to repeat the above exercise on a demo account. Develop your theory based on past data, and then apply it to the current price action without second-guessing yourself or modifying your strategy. Doing this will prove to you how a strategy that seems to work when you fit it over historical data can quickly come unstuck when faced with real price action. Try it out and see for yourselves.