Tuesday, April 26, 2011

Knuth, Trading between the Lines

Trading books often target segmented markets. There are books for system designers and books for those who believe that discretion is the better part of valor, for hedgehogs and foxes, for analysts and traders in need of analysis themselves. Elaine Knuth’s Trading between the Lines: Pattern Recognition and Visualization of Markets (Bloomberg/Wiley, 2011) is the first book I’ve encountered that explains trading in a way that former literature majors can understand. As the author writes in the preface, “Each pattern … is first explained (framed) in a metaphor that fits the idea of the pattern. When reading about the lightning bolt pattern, for example, we first think about what conditions create lightning in the real world, and then within the context of this metaphor the pattern is described. Or when reading about the Icarus pattern, we first learn about what led up to the mythological flight of Icarus. Beyond being simply a pattern name and description, the use of metaphor helps us better understand the concept behind a pattern.” (p. ix) Steering us in this process by way of epigraphs at the beginning of each chapter are the indomitable Don Quixote and his sidekick Sancho Panza. The author justifies her choice, but I nonetheless find the “sane madman” and the “wise fool” disconcerting guides.

It would be easy but foolhardy to say that Knuth simply gives fancy new names to old patterns. She views the market somewhat differently from the norm, so even where a pattern seems familiar the reader is better off letting the author spin her tale and not assume that he already knows the ending.

We encounter such patterns as the knock on the door, the snake, Adam and Eve (similar to but not borrowed from Alan Farley’s short-term pattern), the Titan constellation, and the valley of the kings. These patterns are amply illustrated with charts of stocks and commodities. Unlike most charts that appear in trading books, which are truly “textbook,” Knuth’s charts are truer to life, which means that they are sometimes messy and more difficult to interpret. As the author writes, “A pattern in isolation tells only part of the unfolding story of price action. Trading a classic textbook description of a breakout while ignoring the internals or granularity of price behavior and information around the breakout can (and often does) lead us into chasing one false breakout after another. What distinguishes a real opportunity from a false one may be in the small but essential characteristics of the developing pattern.” (p. 47)

The patterns described in this book are intended to help the trader anticipate change rather than react to it. In part this means that we have to learn to recognize tipping points in market cycles—bear bottoms and bull tops. Although Knuth writes about breakout patterns and continuation patterns in some detail, perhaps the greatest strength of the book lies in her analysis of reversal patterns.

Trading between the Lines is not for the novice who wants a crash course in pattern trading. It is too nuanced. For the trader with a modicum of experience, however, it offers a fresh perspective and new insights. And since the author was a financial journalist before becoming a commodity trading advisor, the book moves along at a rather pleasant clip.

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