Componential Analysis pt.1

The scientific method states that the responsibility of a trader is to explain why a particular movement in a price took place. This explanation cannot be provided by a simple formula, rather one has to strain out many, many factors that led to the final outcome. Componential analysis is based on the fact that the underlying principles that influence the price movement can be divided into multiple components. These components relate to and interact with each other.

There are two basic components that influence the price; the fundamental data and the human response to this data. These elements can then be divided into further components, for example human nature has led to the creation of methods like lines of support and resistance and moving averages as a way of coping with data in space and time. These ideas can then be divided into further components.

The reason for writing about this is because the way that the price moves in the graphs will inevitably evolve over time. This can be seen in that new methods come and then influence the general trend. Gann and Elliott appear to have been influential in their time, irrespective of whether their methods ultimately worked. Also new technology influences how people trade, for example the computer has radically reformed the way that people speculate.

Components can also evolve due to conflictions in methods. Imagine a pair which is significantly influenced by lines of support and resistance and where the 100 moving average is also used. A situation arises one day where the prices utilize a line of support below and the 100 moving average as a line of resistance above. Slowly these two converge and the trader has to make a decision which one is more important. Fundamental analysis may come into play, but a shift in priorities may be indicated if the price bounces off of the moving average and moves through the line of support. If this becomes a repetitive event, then traders will come to understand that there has been an adjustment to the technical analytical framework; the moving average has become more important than lines of resistance/support. This then leads traders to insecurity about the significance of these lines to trading and the whole character of a particular pair can become unstable until consistent results are revealed in the graphs.

A real example can be seen in the article on MACD in Wikipedia. The author says that in the 80′s, this tool was very useful, but more recently it has has been prone to whipsaw, meaning that the price goes in the opposite way than what you would expect. In the one currency pair that I focus on, the reason for this is because another indicator has taken priority over MACD.

The conclusion of this exploration is that traders should be particularly sensitive to the underlying components that influence the price movements in a graph. They should try and have an explanation for as many features of the graph as possible. There also needs to be a monitoring of new additions to, or changes in priorities in the underlying principles.

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