Technical Analysis - Using Price Action to Manage Risk and Look for Profits
My buddy Josh Brown, known to most of you as the @reformedbroker, asked me to put up a guest post on his blog last week while he finished up his book. What I did was talk a little bit about why it is that I look at charts in the first place. I get asked the question so frequently, that I figured it was time to lay down the logic.
Here is the post in it's entirety over at TheReformedBroker:
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Why Charts?
- Joshua M Brown
- June 28th, 2011
Welcome to Guest Post Week here at TRB. JC Parets was a pitcher on Fairfield University's Division I baseball team and is now a Chartered Market Technician (CMT). The competitive drive and discipline required to play ball at that level has clearly informed his trading, he is an absolute monster. I am fortunate to have worked with JC for a number of years and even more fortunate to call him my friend. His stuff can be found each day at his blog All Star Charts. Here he is explaining why he uses charts at all, the logic is unassailable. - JB
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My good friend Josh asked me to put together a guest post this week while he finishes up his book. I thought that I would take this opportunity to talk a little bit about why it is that I look at charts and why the technical approach is my go-to move when analyzing any security.
First of all, that last statement makes a point in itself, "analyzing any security". As a technician, I don't claim to be an expert in any particular area of the market or any specific sector. In other words, I'll look at shares of Microsoft ($MSFT) or Intel ($INTC) the same way that I look at Copper ($HG_F) or Gold ($GC_F). I'll look at the Euro/Yen Cross ($EURJPY) the same way that I will analyze long term Treasury Bonds. Not only can I look at all of these markets independently, but the intermarket work that we do, tying in all of these asset classes together, I feel, really gives me an advantage over market participants that choose to ignore such valuable information.
Legendary Technician John Magee once said that "when you enter the stock market you are going into a competitive field in which your evaluations and opinions will be matched up against some of the sharpest and toughest minds in the business. You are in a highly specialized industry where there are many different sectors, all of which are under intense study by men whose economic survival depends upon their best judgment".
Knowing that going in, wouldn't you want every advantage possible? If there are currency crosses out there that are highly correlated with the equities that you’re trading, wouldn’t you want to know about it?
There were two ways that I was taught to approach the trader's problem of what and when: Technical Analysis, which refers to the study of the action of the market itself as opposed to Fundamental Analysis, which studies the goods in which the market deals. We, as technicians, focus our attention on price because that's the only thing that's going to pays us, nothing else.
Price action reflects shifts in supply and demand. If Demand exceeds supply, prices should rise. If supply exceeds demand, prices should fall. This action is the basis of all economic and fundamental forecasting. We can then turn this statement around to arrive at the conclusion that if prices are rising, for whatever the reason, demand must exceed supply and the fundamentals must be bullish. If prices fall, the fundamentals must be bearish. What we're doing as technicians is indirectly studying fundamentals.
Think about it, if the price of a stock is the result of buying and selling forces, then it represents the "true value" at any given moment. It doesn't make any sense to me to try to compare the market value of a stock with the "book value" or with the "Price to Earnings" ratio. There are too many other factors that may also affect the value, and some of these cannot easily be expressed in simple ratios.
I'm sure there are plenty of "reasons" why markets go up or down. I just don't think that knowing what those reasons are is necessary to the forecasting process. Fundamental guys study the cause of market movements; we choose to focus on the effect. All known facts, estimates, surmises, and the hopes and fears of all interested parties are integrated in this effect (price). The Fundamentalist always has to know why, but why doesn’t pay us. More importantly, from a risk management perspective, I cannot imagine how difficult it must be to manage risk if you’re not using price action as a guide.
Hypothetically, a fundamental analyst does his math and puts a fair value of a stock at let’s say $15 and the stock is currently at $12 – it’s a buy right? So you purchase 10,000 shares at $12 and a week later the stock goes down to $10. No news, nothing has changed with the company, but now you’re down over 16%. Without any significant news events or company altering announcements your opinion of the stock has not changed. Do you buy more at $10? Do you put good money after bad? Regardless of your decision, you’re not selling right? The Stock is worth $15? Ok so 2 more weeks go buy and the stock has deteriorated further down to $8. Now what? You’re down 33% in a stock that you thought was worth $15. Where is the risk management? When do you know you’re wrong? Do you buy more at this point? Do you sell? What if the stocks goes even lower? These are all questions that I wonder to myself when I see this sort of analysis.
As technically driven as I am, sometimes I'll look at fundamentals out of sheer curiosity and interest. A perfect example is $AAPL vs $RIMM. What a successful pairs trade that has been for years. I love apple products, always have, but I think blackberrys are horrible devices in comparison and Research in Motion is a company in a dangerous position. But it doesn't matter what I think, price tells the story.
I'm not trying to put down any other form of analysis. In fact, I have the utmost respect for a ton of traders and analysts that focus their attention on fundamentals. Some of them even use both. They do great work and whatever it takes for them to get the job done, then more power to them. We have very busy days and this crazy market doesn't give us too much time to think. So I've chosen to keep my life simple and focus all of my attention on the only thing that matters, the only thing that is going to pay us, and that is price.
I would just like to reiterate that I would still buy a stock where technically I agreed but disagreed on the fundamental premise. But never ever ever under any circumstances would I buy a stock that I liked fundamentally where technically it just offered too much risk for the potential reward. So if that's the case, and I recognize it, then why wouldn't I just look at the charts?
Sources:
Technical Analysis of the Financial Markets - John Murphy
Technical Analysis of Stock Trends - Edwards and Magee
Technical Analysis Explained - Martin Pring
Cartoon on Chartists (Alpha Global Investors)
