Basic Price Oscillation

Importance of focus on price

In Pyramid Investing, it is crucial to recognize the importance of price. Price is King! Everything revolves around price – our feelings, our actions, our profits. We may disregard many other aspects of investing and still manage to come out whole at the end. However, neglecting the price is a catastrophic error in financial sense. The price importance may seem obvious and it may appear impossible to lose track of price, but in reality, many market participants tend to become preoccupied with everything else but price.

In Pyramid Investing, price is constantly in our focus. We take care of many aspects of investing along the way. However, our actions are solely determined by price. We plan and prepare for every possible scenario but when certain price levels are reached, actions follow immediately with no hesitation whatsoever.

Volatility

Price constantly goes up and down whenever market is open. Sometimes it changes more, sometimes it changes less. This phenomenon of constant price moves is called volatility. Volatility is affected by many different factors: market news, investors’ feelings of greed and fear, liquidity, sectors, seasons, time of the day etc… Volatility exists whether we like it or not. Some investors are scared by volatility and they try to avoid it or reduce the exposure to volatility at almost any cost. That is mostly the consequence of number of myths and investing misconceptions. It is also true that some investing techniques are not designed to withstand excessive volatility.

Conversely, Pyramid Investing happens to be an investing concept that embraces volatility. We realize that if there would be no price changes, no profits could be made. The concept exploits price increases to book profits and price decreases to prepare for future profit booking. Every change in price is welcome. As a matter of fact, the more the price changes the better and the more frequently it changes the better. This sounds like not only that volatility is fully embraced but it is wished for!

Wondering about price

Even the most inexperienced lay investor understands very well that price changes all the time. However, the notion of ever moving price is not enough. Certain questions are normally asked:

How does one make sense of price and price moves?
How fast do prices change and what makes them change anyway?
How do we react on price changes and do we always need to react?
How do we anticipate future prices and how much and in what direction are they going to change from here and now?
What is the relationship between price and profits and why it is so important to respect price in order to make profits?

These are examples of questions that naturally run through every investor’s mind. It may be impossible to answer some of these questions, but as you will realize later, we don’t need to answer all these questions in order to make money in the market! Some price related questions are actually irrelevant but that may make things worse since we need to identify those to not bother answering them. On the other hand, finding answers to some other questions may be critical.

Assumptions

In order to make sense of price moves, we need to define basic price oscillation. But prior to that, I would like to mention a few important assumptions:

Price changes in time. For now it doesn’t matter what the rate of change is. In other words, we are not concerned by how fast the price changes.
We neglect the short time periods when the price does not change. If we pick period long enough, the price changes for sure. “Long enough” may be one second, one minute or even one day but very likely less than just a few minutes.
Price can start changing upwards or downwards from a certain price at a given time instant. For the sake of simplicity, we observe downward move as an initial move. As we will learn later, the quality of our analysis will not be diminished by this simplification.
We use term price without any specific investing vehicle in mind. It may be price of stock, bond, silver, mutual fund, futures contract etc… The concept of price analysis is same and equally important regardless of investing vehicle in question. Actually, we will often refer to stocks but by no means will we be limited by stocks.

Basic price oscillation definition

In general, price charts show complex patterns and most of the times erratic price moves (see Figure 1 as an example of price chart, courtesy of Google finance).

Fig.1. Example of price chart and erratic price moves

Contrary to beliefs of many technical analysts, future price moves are impossible to predict with great (if any) certainty. But that is not the point at this moment. The idea is to define the basic price oscillation that can be used to build any price chart, no matter how complex it may be. To help us with basic price oscillation, we analyze a simple price chart given in Figure 2.

Fig.2. Basic Price Oscillation

We can observe a simple “U” or “V” shaped price oscillation. As assumed above, the price starts with a downward move. It reaches some lower price, turns around and continues with an upward move all the way to initial price. Since the price ends up where it started, we use the term oscillation. We are not concerned with the rate of change, thus time designations on time coordinate are intentionally omitted.

Looking at the price coordinate, we can observe three discrete price levels:

Top is where the price starts and eventually comes back to. It corresponds to price p₀.
Price runs through one step lower price level on the way down and again on the way up. This middle price level corresponds to price p₁.
Finally the price level that corresponds to price p₂ is never reached. The price turns around before it drops to this price level. This level is again one step lower from the previous price level.

In accordance to previously defined Pyramid Investing terminology, we use Depth to designate how many discrete price levels the price drops relative to the Top. As a matter of fact, this basic price oscillation can be defined for any three price levels. Since our objective is to implement basic price oscillation to Pyramid Investing, it is convenient to use related terminology from the very beginning.

Therefore, our three price levels are shown by three horizontal green lines and designated with Depths 0, 1 and 2. The price curve is shown by thick black line. How many intersections can we observe between price curve and price levels? First, the price never reaches bottom price level, so no intersection there. There are four intersections above – two with top price level and two with middle price level. Each of those two price levels is crossed twice: first when the price goes down and again when the price goes up.

Actions and trades

Now, let’s see what happens at each intersection:

First intersection is where we start observing the price movement (Depth is 0). That is likely the current price of underlying stock. At this intersection we only make note of the price so we can possibly act on it later. At this time, we should already have in place the pyramid we want to apply.
Second intersection is where price crosses the middle price level on its way down (Depth is 1). Since the price comes from some higher level, this is considered to be price weakness. We buy predetermined amount of shares at this intersection.
Third intersection is where price crosses the middle price level for the second time (Depth is 1), but this time on its way up. No action is performed at this intersection.
Fourth intersection is where price recovers and crosses the initial level we took note of earlier (Depth is 0). Since this time the price comes from lower level, this is considered to be price strength. We sell predetermined amount of shares at this intersection.

In this basic price oscillation example we have two trades: one buy and one sell. The amount of sell is same as the amount of buy, i.e. we sold everything we bought. The colors of transaction rectangles are standardized to: blue for buy and red for sell.

Smooth curve and insignificant intersections

We can also make observation that black thick price curve is smooth. In reality, during very short time periods, price changes suddenly and abruptly. The curve is never perfectly smooth (take a look again at Figure 1). Even during longer time intervals, price never goes straight in one direction. It is common to experience many smaller ups and downs either when it trends upward or downward. For the purpose of Pyramid Investing, these small price digressions can be ignored and the curve is smoothed to make it more practical. It is intersections of price curve and discrete price levels that we are primarily interested in.

However, not even every intersection is significant. Take a look at the Figure 3. Here we have a price curve that crosses Depth 1 level four times! We see that when this level was crossed for the first time, the purchase was made. Trade at certain price level actually disqualifies that price level at least until next trade occurs at some other price level. Therefore, no matter how many times the price crosses disqualified level, no action is performed. We will analyze this dynamics in more detail later on.

Fig.3. Example of intersections of no significance

Finally, let’s reiterate the most important aspects of basic price oscillation: Basic price oscillation is change in price along simple “U” shaped curve. Price drops little more than one step before it fully recovers. One purchase and one sale may occur as a consequence of respective price weakness and strength. Basic oscillation can be scaled and inverted and then repeated as necessary in order to create price charts of arbitrary complexity.