Technical analysis, a.k.a. chart reading, is one of the oldest market disciplines, yet the majority of professional investors consider it, at best, a minor supplement to their own work.
At worst, it is belittled as tealeaf reading or simply a self-fulfilling prophecy. However, in recent years, the profession has made strong inroads into the investment and academic communities and in an age when fundamental analysts have been taken to task over their performance in bear markets it is no wonder.
The technical method looks at actual trades when bulls and bears have put their money where their collective mouths are. And contrary to what critics might think, there is no mystical divining of the future. All market and stock selection is based on supply and demand and the behavior of crowds and as such is rooted in social science, not sorcery.
Why Is This Important?
Technical analysis is important because it helps traders and investors understand not only where a market is but also how it got there. Market participants, as emotional human beings, tend to behave in similar manners given similar circumstances, so if we can figure out the circumstances (chart patterns, trends, and sentiment) then we are well along the path in figuring out what they are likely to do next. After all, they’ve done it before.
In addition, technical analysis is the only market analysis method that can explain why there are discrepancies between theoretical value and actual traded prices. Fundamental analysis may be great at determining what a stock is worth, for example, but it does not explain why it is not trading at that level at any given time. Charts reveal the psychology of the marketplace and the difference between perception and reality.
Technical analysis has an unfortunate name. Perhaps “price action analysis” or “supply, demand and reaction analysis” might be better. In academic circles, the term “behavioral finance” is emerging and that is a far better concept to promote.
Such terms as head-and-shoulders, rounded bottom and double zigzag may sound quite arcane to the casual listener but being the clever souls they are, chartists just name them for what they look like. A flag pattern looks like a flag on flagpole. A double top has two peaks at the same price close together in time.
Jargon is everywhere in technical analysis but it need not muddy the waters of understanding. The budding chartist will do just fine with up, down and sideways to describe how prices are moving over time. Strip away the names and whiz-bang concepts and that is all that really matters. Buy it when it is going up. Trite but true.
But Really, What Good Is It?
Charts and indicators are tools, not magic bullets. They are not crystal balls to help us see into the future. That would be like using a tire gauge to predict how many miles per gallon your car will get. True, properly inflated tires will last longer but that’s all we can know before starting the automotive journey. In the markets, properly positioned stocks or bonds give us the OK to hop aboard, not knowing exactly how far the ride will be or how long it will last. We can relate back to previous times we got that OK to give us an idea of how far to ride but we will never know for sure up front. And when it is time to end the ride, the charts will tell us that, too.
In part 2 of this tutorial, we’ll cover how charts actually help traders and investors make better decisions.
Michael Kahn writes the twice-weekly “Getting Technical” column for Barron’s Online and edits the daily Quick Takes Pro newsletter. He is also the author of three books on charting, the most recent being “A Beginners’ Guide to Charting Financial Markets.” Read his blog at www.quicktakespro.com/blog.