Why Technical Analysis Matters

Early in my career, I learned (the hard way) that if I didn’t study price action, I was in trouble. Sure, sexy stock stories are great for cocktail parties, but boring old price is the only thing that’s going to pay. So Technical Analysis is the study of the behavior of the market and it’s participants. If price is what pays, then that is where we focus our attention. It may seem obvious to do that, but you’d be surprised as to how much time people spend on all the other nonsense.

Back in 2006, Chartered Market Technician Michael Kahn wrote a great piece for Barron’s about why technicals matter. Now is probably as good a time as any to share a few of my favorite lines:

Unlike Fundamental analysis, which is dependent on future earnings and revenue estimates, technical analysis helps investors by focusing on what the markets have actually been doing.

At its core, technical analysis, also known as stock charting, is simply a method of determining if a stock or the market as a whole is going up or going down. Once we identify these trends, and that is something we can do by simply looking at a stock chart, we are way ahead of the game with regard to assembling a winning portfolio.

Like other technical analysts, I use data generated from the stock market and from the actions of people in the market. Such data includes the amounts of stock being bought and sold each day, the rate of change of price movements (momentum) over a given span of time and analysis of price levels that have served as turning points in the past.

For example, if a price of $50 for a stock brought out the sellers on one or two occasions in the recent past, this price level is considered to be “resistance,” where the supply of stock increases relative to the demand. People think it is expensive so they attempt to sell. Simple economic theory suggests that prices will stop going up, if not actually decline.

Technical analysis also attempts to measure the collective investor psyche, calling heavily on the psychology of crowds and the cycle of greed and fear. If everyone thinks one way, the odds that the market thinks the other are usually high.

Contrast that to the more ephemeral fundamental analysis, the standard analytical backbone of Wall Street for several generations.

Fundamental analysis, which seeks to uncover the intrinsic or true value of a stock, is dependent on future sales, earnings and cost estimates of a company being studied. Often, these numbers change as circumstances, such as the overall economy or the competitive landscape for a company, change.

By contrast, the inputs of technical analysis — the price of shares and the volume being sold — never change after the fact. Charts are never revised later.

Since chart watching is not infallible, an even more important aspect is that it will tell us quickly if our assessment of the market’s mood is incorrect. For example, if prices move higher from the triangle pattern in the chart and then fall back within that pattern, we will know that we were incorrect in our original decision to buy. Either we missed something on the chart or the market simply changed its mind and decided to go down. We sell immediately and book our small loss, leaving our egos at the door.Something chart watchers keep pasted to their computer screens is a sticky note that says. “All big losses begin as small losses.” When the initial reason for buying is gone we don’t hang around hoping it will go back up. Hope is a four-letter word in the world of investing.

If a chart watcher follows breakouts, he or she will inevitably have losing trades. But if he or she is disciplined and responds to breakout failures, the losses will be small and easily overwhelmed by the profits from winning trades.

Chart watching can trace its roots back more than 200 years to Japanese rice trading. Charles Dow, a forefather of modern technical analysis and a co-founder of Dow Jones & Co., the parent of Barron’s Online, made his ground-breaking observations in the late 19th century.

Analysis was done with paper and pencil for decades until personal computers made their appearance and with computers, the sophistication of the analysis blossomed.

Over the past 20 years or so, charting has spread from a few Wall Street analysts with access to price and volume data to the mainstream. With the explosion of trading activity by individuals in the 1990s, the markets became incredibly liquid and technical analysis was perfectly suited to take advantage of the activity.

I recommend restricting technical analysis to stocks that trade at least 100,000 shares per day so that there is a liquid market for the stock.

Michael Kahn made some great points in his article. He wrote this for Barron’s over six years ago, but the things he says are obviously sill very relevant today. “Inputs of technical analysis — the price of shares and the volume being sold — never change after the fact. Charts are never revised later”. Love that!

Go check out Michael Kahn’s blog at QuickTakesPro

And be sure to follow him on Stocktwits and Twitter at @mkahn



Why Technical Analysis Matters (Barrons)