Part 1 of a Series of 4 Educational Posts on Everything You Need to Know about Technical Analys

“You see I can predict this stock went down!”

“You see I can predict this stock went down!”

            The day-to-day movements of the market are a combination of emotion, fact, and rumor served up on a global platform. Human emotions, news, and talking heads are all mixed up into an electronic cocktail of red and green lights. There are two ways of making some sense out of this. There is the fundamental approach, which analyzes a company’s earnings, their debt-to-capital ratio, their price-earnings ratio, cash flow, capabilities of management, and a whole host of other quantitative and qualitative measures that determine a company’s current and future prospects. Then there is the technical side of analysis that looks at the price of the underlying security in relation to prior prices and volume.

Technical analysis takes a completely different approach than fundamental analysis. It doesn’t care one bit about the “value” of a company or a commodity. Technicians (sometimes called chartists) are only interested in the price movements in the market and will often remark that all news and fundamentals are already reflected in the patterns of the charts. I love them because you need to have someone to bet against and blind adherence to any investment strategy has pitfalls.  Don’t get me wrong. I believe in charts but one piece of news has the potential to blow apart the best of chart patterns.  Anyone that believes otherwise is fair game.

            Technical analysis is controversial. There are a lot of very successful investors that believe charts are complete nonsense. Keep in mind, though, every major Wall Street firm employs technicians today.  You invest at your own hazard when you ignore what the big money does.

There are dozens and maybe hundreds of technical indicators. Fortunately, most of these are worthless, so you don’t have to expend a lot of brainpower understanding arcane math formulas or bizarrely named chart patterns. I only look at a few technical patterns, and that’s the result of years of running computer programs that back test dozens of these indicators on thousands of different securities. (I think back-testing is a waste of time. You can only buy or sell now or sometime in the future, not the past. When someone comes up with a future testing solution, I’ll listen.)

Most importantly, what I’ve learned is borne out from experience, the school of hard knocks—whatever you want to call what happens when you start using real money. If you are using raw computer power to find patterns, you will. Some indicators worked better than others on certain stocks—until they didn’t. My proof was my money line. It wasn’t growing. Believe me, using play money or simulated trading accounts is nothing like the real world of watching your precious nest egg dissolve in front of your eyes. It reminds me of heavyweight champ Mike Tyson’s comment, “They all have a plan until they get hit.”

Technical Analysis is Always Right… Until its Wrong

Every day I used to run a software program, comparing the entire S&P 500 against a universe of technical indicators. Astoundingly enough, many stocks showed reliable patterns. Some indicators DID work better than others. There was no doubt about it. It was quantifiable, repeatable, and visible right in front of your face. However, just because an indicator worked well for some period of time, there was no assurance that it would continue to work well.

            Nonetheless, I do believe technical analysis is incredibly important. It’s ironic, but while I don’t believe in 90% of of the technical indicators, the 10% I do believe in holds a powerful sway over my thinking about markets and making money in them. So in these pages I’m not going to waste your time and explain a bunch of technical analysis indicators you will never use. Instead, I’ll cut to the chase. The three tools I am sharing with you are all you need. I daresay anything more will even hurt your performance.

         (For a more comprehensive survey of technical analysis, check out John Murphy’s Technical Analysis of the Financial Markets: A Comprehensive Guide to Trading Methods and Applications. TradeStation’s own dictionary of technical analysis technical indicators is an incredible online help platform that provides a brief explanation of each indicator. While it doesn’t go in-depth into the formulas that calculate them, like Murphy does, it provides fantastic illustrations of how they look and work in their particular platform. One of the true marvels of computing is that complex math formulas can review years of daily data of the high, low, and close prices of stocks, and can render instant plots of whatever you can dream of.)