Let’s see how these 3 TA principles (from the previous blog post) play out in life and why people create patterns.

You fly into a foreign country you have never been.  Your flight lands and you are starving. No clue of where you are for food, but you stumble across a couple of Mexican restaurants (one across the street from the other).  The first thing you notice is one of the restaurants is packed with customers and there is even a line out the door. The other place just has a few people you see through the window sitting inside and the tables are mostly empty.  

Your stomach churns for a burrito, so which one do you choose and why?

An interesting fact: most people will end up going to the packed restaurant and even wait in a long line.  But, what if the empty restaurant is cheaper, has tasty burritos, or has bettered service? 

In reality, none of these factors will matter.

People want what other people have (naturally), and they feel a level of comfort from following the choices of others rather than having to think for themselves in many situations. It partially explains why we see a lot of people buying stocks, indexes, or cryptos at the exact wrong time (i.e. $19000 Bitcoin).

While we may not realize it, there is a social mood wrapped around us all the time, and most of the social mood is subconsciously registering inside our brain. We use “social mood” to decide what clothes to wear, what house to buy, what car we drive, or even what stock, index, or crypto we jump into.  Markets do not act or react like the economic factors of supply and demand, they act like “fear and greed” financial markets.  

Let us look at a made-up scenario:

The price of a big screen TV goes from $200 to $1000.  Economic books teach us when price goes up, demand falls. Fewer people buy when prices rise.  Well, I hate to break it to you, but financial markets do not work that way. When the price of a stock, index, or crypto goes up, the demand goes up.  More people buy when prices rise (or in this example, trend).  

So, when you examine the emotional response on which Mexican restaurant to pick (financial thinking) comes into play on how human nature is wired.  The majority thinks … everybody is in line at the one restaurant, so I must go with their decision (it must be good). Go where everyone else goes, they must know what is right.  Wrong, if you act in this way you are likely acting in the wrong manner.

This analogy helps explain why technical analysis is a great tool.  With all the news already out there, people and patterns are creating the same trends over and over.  This creates the three main tenets of technical analysis we discussed in the previous blog post.

Markets discount everything

Trends are created

History tends to repeat itself