Combining Intrinsic and Extrinsic Bias

Combining Intrinsic and Extrinsic Bias

Technical signals arising from price action can be divided into two categories: intrinsic and extrinsic. Signals derived from the sentiment inherently associated with a particular chart pattern fall into the intrinsic category. For example, a double, triple or multiple bottom pattern is intrinsically bullish whereas a standard head and shoulders pattern is intrinsically bearish. Extrinsic sentiment comes from the location of a pattern. For instance, a pattern occurring at an area of prior support is extrinsically bullish whereas a pattern occurring just below a falling moving average which is acting as resistance in extrinsically bearish. In summary, intrinsic bias depends on the type of chart pattern whereas extrinsic bias is concerned with where the pattern occurs.

Most chart patterns have some form of intrinsic bias. The most commonly recognised patterns can be classified as in figure 1 below. Figure 1 can be downloaded here.

Figure 1

Intrinsic bias may be bullish, bearish or occasionally neutral in the cases of symmetrical triangles or horizontal channels. While being aware of intrinsic sentiment will give traders a better idea of where a market is likely to go, on many occasions the market will move against the intrinsic sentiment of a chart pattern. This may be because a pattern is actually a smaller part of a larger pattern with conflicting sentiment. In this case, larger patterns take precedence.

In order to increase the likelihood of accurately forecasting the direction of the market following a chart pattern, intrinsic bias should be considered in tandem with extrinsic bias. When both intrinsic and extrinsic biases are in agreement, that is both bullish or both bearish, trades can be entered with greater conviction than those entered based on either intrinsic or extrinsic bias exclusively. Observe how in figure 2 a descending triangle occurs on the daily chart of EUR/GBP.

Figure 2

The descending triangle is a bearish pattern, but look where it occurred in context. The bottom of the triangle coincides with a cluster of two Fibonacci levels of different ranges; the 0.5 from the solid levels and 0.382 of the dashed levels. This suggests strong support and is bullish. Here intrinsic and extrinsic biases are in disagreement. Trading based on the pattern alone would have resulted in a loss.

The daily chart of USD/JPY in figure 3 presents a different situation where intrinsic and extrinsic biases are in agreement.

Figure 3

A head and shoulders pattern occurred such that the head forms a top at the 0.618 level of a previous downtrend. Both the head and shoulders pattern and the significant resistance level are bearish indicators. This market action allowed traders to enter short positions with conviction knowing that intrinsic and extrinsic biases coincided, making further bearish action highly probably. The market did continue to decline below previous support to below 85 JPY marking a 15% fall from the peak of the second shoulder.

Of course, no setup can guarantee where the market will go irrespective of any number of indicators in agreement. Technical analysis deals in probabilities, never certainties. But ensuring intrinsic and extrinsic sentiments are in agreement will generate a superior success rate to relying on either one or the other.