Millard on Channel Analysis. Brian Millard
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reluctance to sell. If we are going to work to any set of rules, the reasoning behind them must be perfectly clear, so that those occasions when the share price does not seem to be following the rules can be understood for what they are – times when we have to be more flexible about our interpretation of the rules.
By this more logical approach of trying to understand why share prices move as they do, we should be able to improve our predictive techniques so that we can almost always recognise the start of a new upward or downward trend. We will be able to recognise when we have made a mistake about the start of a new upward trend, and be able to act quickly to close the losing position before the loss is anything other than a trivial one. We will be able to follow the old stock market rule: “let your profits run and cut your losses”. This will be a great advance for most investors, who seem to do exactly the opposite, selling the share when there is still plenty of profit to come, but staying with a share which is falling rapidly, because they are convinced that it will soon change direction.
ARE SHARE PRICES RANDOM?
The simple response to this question would be to point out that the world’s stock exchanges depend upon prices not being random. If they were random, then one might as well pick shares for investment with a pin, or forgo the stock market altogether and leave one’s money in the money market, earning the best rate of interest available. The vast array of stock market analysts employed by various institutions would be totally superfluous and investment writers like myself would have to turn to other activities.
The existence of investment commentators, besides indicating that the movement of share prices may not be random, also raises an interesting philosophical point. Their existence may be the reason that share prices are not random, in the sense that their comments in newspapers may distort what would otherwise be a random process. Just suppose, for example, that Guinness shares were moving in a random fashion until one day the investment columns of two or three newspapers suggested that Guinness shares represented a good buy. Many of their readership will take their advice and start buying these shares. The inevitable logic of supply and demand dictates that the price of Guinness shares will then start to rise. If these same newspapers continue to push Guinness shares as a good buy, then more and more readers will begin to take notice, and the share price will continue to rise. The rise will not continue forever, but at some point will reverse itself. This is because an increasing number of these new holders of Guinness shares will decide that they have now made sufficient profit to have satisfied their objectives, or will decide that all good things must come to an end, and will now act in a contrary way to the advice being offered and will sell their shares. This selling pressure will increase, thereby causing the Guinness share price to fall. Eventually we can conclude that the Guinness share price has reverted back to its original random movement.
This example serves to show quite clearly that even if we accept the premise that some or most of the time a share price is behaving randomly, then there will be occasions when because of press comment the price will move in a non-random manner. This can be illustrated by the type of movement shown in Figure 2.1.
Figure 2.1 Random price movement becoming non-random for a period of time due to favourable press comment
Just to restate the position so far: we assumed that the Guinness share price was moving randomly until a random event (comments in newspapers) caused the price to move in a non-random fashion for a period of time. The non-random movement was caused by a bandwagon effect of investors reading and acting on comment in their newspapers.
A closer inspection of Figure 2.1 shows that the day-to-day fluctuations, when viewed in isolation, are still apparent even when the underlying long-term trend is rising.
Since we can accept that a random event such as a newspaper article was the trigger to an upward and then a downward price movement, it is but a short step to an improved model of share price movement:
1 Share prices contain random day-to-day movement.
2 Share prices contain upward and downward trends.
3 The start and end of a particular trend is a random event.
By the word “trend” we mean an underlying price movement that lasts for more than a few days, and may last as long as many years.
To determine that prices are or are not random is difficult, and would take us into a realm of mathematics that would be out of place in a book of this nature. However, we can make some progress by taking a simpler approach. To do this it is necessary to take a close look at daily price changes in a share such as Guinness. In Figure 2.2 are plotted the daily changes in closing price, over a 1000-day period up to September 1996.
Figure 2.2 The daily price changes in Guinness over a 1000-day period are plotted as relative frequency of occurrence of a change versus that change
The plot shows the relative frequency of occurrence of various price changes, with the most frequent change being zero, i.e. the price on one day is the same as that on the previous day. For comparison with Figure 2.3, the most frequent occurrence is given a frequency of 1. The largest changes shown in the figure are a rise of 21p and a fall of 21p.
The important feature of Figure 2.2 is its shape, rather than specific values.
If daily price changes in Guinness over the period of time in question were totally random, then the shape of the curve in Figure 2.2 would be identical with that shown in Figure 2.3, the classical probability shape. It can be seen that the general shape of Figure 2.2 approximates to the probability shape, with the main distortion being that the central value, corresponding to zero daily change, is too large. If this value is reduced, then the shape gets closer to the ideal, with most frequencies not too far away from the value predicted for total randomness. Thus a simple deduction from the shape of the curve in Figure 2.2 is that there is a great deal of random behaviour in the daily change in the Guinness share price, and that the major departure from total random behaviour lies in the greater than expected incidence of no-change days. Thus we can say that random and non-random daily behaviour are co-existing.
Figure 2.3 A totally random distribution of daily price changes would have the shape of this curve
A moment’s thought would lead us to the proper conclusion that since there is an indeterminate amount of random behaviour in daily price movements, and that the majority of daily movements lie within the range of plus or minus 10p (Figure 2.2), there is no profit to be made in an investment made solely on the basis of a prediction of the price movement on a particular day. We need to move from daily movements to longer-term trends where the price movement is much larger.
The first, inescapable conclusion is that since daily movements exhibit a high degree of randomness, then price trends over a succession of days built up from these individual movements must also show a high degree of randomness. This can be addressed in an unusual way.
In Figure 2.4 we show the chart of the Guinness share price covering the period since 1983. The data are weekly in this case in order to present a long price history. It can be seen that a long-term uptrend was sustained from September 1988 to mid-1992, before the price retreated somewhat and then stayed within a trading range.
Figure 2.4 The price movement in Guinness shares since 1983. The data are plotted weekly
Except for the fact that the timescale is very much longer, the chart resembles Figure 2.1, where we took the example of a random movement that then became transformed into a non-random movement by press comment. In Figure 2.4 we appear to have a random price movement occurring, which then develops quite obviously into a non-random movement for reasons which are not