Time for a Little Technical Analysis

Technical Analysis Could Save You as the Markets Unravel

Even though I believe fundamentals such cash flow, earnings growth and profit margins ultimately bear out in the fullness of time, we know markets can remain “irrational for longer than you can remain solvent”. Because, unlike Warren Buffett I don’t plan to holding stocks or living forever, I always use charts as my starting point for identifying attractive risk/reward entry points and keeping realistic exit goals.

Over the past few weeks as the market has recently become unhinged from fundamentals and buffeted by macro concepts such as currency devaluation, using technical analysis to has becoming increasingly important tool to both churning out short term trading profits and being patient in establishing longer term positions.

It was interesting to see that even during the “flash crash” when trading hit a vacuum on the opening two weeks ago many stocks and ETFs held right at old support levels.  Here but two of the many examples:

SPY held right at the old October low.

SPY Flash Chart 9.8.16

Amazon perfectly held support from its April earnings gap at the $452 level.

AMZN chart Monday flash 9.7.15

Why does technical analysis work?    In one sense technical analysis can become self-fulfilling as market participants are all looking at the same important price levels. These levels start to build up the volume as the tug of war between bulls and bears plays out. One a level is broken it tends to see follow through as the side that won gathers steam and the losers capitulate.   These often leads to a new trend which can be followed successfully for weeks or even months.

On the other hand a “failed breakout” or head fake can often lead to large sharp move as those looking to jump on the new trend are left holding the bag. How to differentiate between a true break is often a matter of experience and also being patient in waiting for a confirmation of the new pattern.

Pattern Recognition: Amos Hostetter, a well known and successful trader from the 1950s when asked how he did it would throw his charts on the floor and jump on his desk to make a point, saying, “the charts will tell you!” The point is that he liked to see a pattern that is identifiable from across the room. This will give you the big picture.

chart patterns guide

Focus on patterns like these rather than all the lines some people like to scribble up and down and all around the page. Crystallizing the true best-in-class opportunities, you will go far in extracting yourself from the clutter and the noise that bleeds out many traders.

Price awareness and clean pattern recognition on a chart level are not the only tools to becoming a master trader, in our view, but they represent essential and useful beginnings.

Time Frames: A clean weekly chart is one of the best things in the world for traders. It goes back to basic principles of ebb and flow and major market movements. Where does the actual power of charting come from? Many traders believe weird things about charts. They assign mystical properties to what is essentially little more than an abstract data set. What is a chart at the end of the day, really, other than a visualized form of data put together as lines and bars on a page?

You can make a chart of almost any data set, and do things to manipulate the appearance. A trader could probably find hundreds of setups per day were he to scan through thousands of five-minute chart but most of them would have a vanishingly short half-life before decaying into randomness.

Charts can also guardrail, and a signaling device for fundamental hypotheses. If you have a certain belief about “the market script,” or a specific company outlook, the behavior of price can tell you whether markets on the whole are confirming or disconfirming your thesis. This then creates opportunity for further investigation, in the name of revising or updating your views. And charts can highlight excellent risk-reward opportunities, when all the relevant factors come together and align in a powerful way.

But in order to get maximum value from charts it is necessary to refrain from asking them to do too much. Many traders approach charts like detained crime suspects, to be interrogated or even tortured until they “confess.” Without objective standards as to what constitutes a usable price pattern and what does not, we become prone to subjective bias in which the chart becomes a rorschach test, allowing the trader to “see what he wants to see.”

As the market tries to find its footing following the August decline using technical analysis can help filter the noise and identify high probability trade signals.

— Steve Smith

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About the Author: Steve Smith