Why higher timeframe analysis has higher accuracy?

In technical analysis, the term "multi-timeframe analysis" is commonly used. The concept discusses about looking for trades after looking multiple timeframes and see if you are consistent with the higher timeframe. This avoids taking trades that are not in line with the higher timeframe and might turn into losses. Traders will agree that higher timeframe give more clarity into the overall market scenario. A trending market in intraday would appear sideways in a daily chart. But why does higher timeframe analysis has higher accuracy? Traders might have known it and understand the logic behind it. However, the attempt here is to explicitly mention the mechanism behind this basic characteristic of market.

To understand the reason behind the higher accuracy of higher timeframe, we need to understand three concepts very clearly- Float, law of Supply-Demand and types of market participants.

1. Float: the total number of shares of a company available for public to trade is called float of the stock. Restricted shares are deducted from total shares to get the float. Restricted shares are not available for public trading as this requires certain conditions for it to be bought or sold. A liquid share will have high float and hence the buying and selling is easy in such stocks without any slippage.

2. Law of Supply-Demand: this law states that the prices will go higher if the supply is less than the demand and the prices will go down if the supply is higher than demand. This is one of the fundamental theories in economics. Since stock exchanges are largely markets for equity , the law of supply and demand will hold true.

3. Types of market participants: Participants can be classified in following basis the timeframe they hold the stocks.

• Investor: These are participants that invest in a stocks taking a long term view. The usual horizon may be 1year to several years. Investors will analyze the fundamentals and business model of the company and then make a view on the company.

• Swing trader: These participants will be investing in a stock basis the daily/ weekly movement expected in a stock. Swing traders may hold the trade for few days to couple of weeks.

• Intraday trader: An intraday trader will not take the delivery of a stock and will close the position by the end of the day. These participants can hold a short position on intraday basis. Investors or swing traders can't take short positions in Indian market.

• Scalpers: These are intraday traders who will hold the trade for few second to few minutes.

After understanding the above concepts, let's try to imagine a situation basis a simple strategy and what will happen to the float of a stock. We will take simple cross over strategy of 9 EMA and 20 EMA. All the participants will take a long trade when the 9 EMA crosses 20 EMA and sell when the 9 EMA crosses below 20 EMA. Investors and swing traders cannot take any short position when the 9 EMA crosses below 20 EMA. Investors will take the long position basis weekly chart, swing traders will take long positions basis daily chart .Intraday traders will take trades basis the 15 minute chart and the scalpers will take the trade basis the 5 min chart.

Now see the table below. This is a simplified diagram to show how the float is getting effected with change in technical data in different timeframe.

Change in float available for trading

We can see that in the beginning 9 EMA was trending below 20 EMA. The company had a good year and the yearly profit increases. Institutions start buying the stock basis their calculation of fair prices. Due to this buying, the weekly 9 EMA crosses over 20 EMA. This is being noticed by other investors and they steps in and buy the stock, and thus block the float from the overall pool. Now these investors will not bring their shares to exchange for selling until there is an indication to sell from the technical data. Because of this float blocking, the supply of share gets reduced in the market and the prices go up to manage the demand. This causes the daily 9 EMA to cross the 20 EMA. This will invite the swing traders to buy and block the float some more. Similar to the investors, swing traders will not be bringing their shares into exchanges and further reduce the float. Since the float has been blocked by investors and swing traders at this moment, the supply is reduced. The prices will move up to compensate for it. Intraday traders and scalpers will enter the short trade whenever the signal comes in their timeframe. But the issue with intraday traders is that they have to square off their position and any short selling needs to be covered and hence more buying happens. The beauty of stock market is that the trading rules will be different for all the participants. This process when combined with different strategies, different rules, size of traders becomes very complex. With different rules on profit booking and exiting the trade the float varies. However, in every strategy the same principle will be applicable.

This example takes only one of the cases where the higher timeframe has been correct in taking the trade. This does not mean that higher timeframes will get it right all the time. However, the float gets effected when the higher timeframe participants take action.

Some people might use RSI as an entry criteria or someone might use some different set of indicators or technique to find trades. The point of this example was to show how higher timeframe invites participants who will effect the float of the stock and thus the prices. Shorter timeframe participants will not be able to effect the float as much as the higher timeframe participants. Since the higher timeframe participants enter in the trend, the exit from the trend will also be last. And when they exit the outlook becomes negative and float starts unblocking. All the participants will feel the increase in supply and thus there will be consensus among the participants about the direction of prices. This helps us to plan the trades as the best trades are the one where a majority of participants think alike and hence the momentum will be quick. This consensus gives us the edge in higher timeframe and thus the higher accuracy.