[Editor's Note: This is a guest post from The Wall Street Physician, a physician financial blogger whose former life was a Wall Street trader. We have no financial relationship.]
I’ve been an avid follower of the financial markets since high school and I remember immediately being drawn to the beauty and elegance of technical analysis. Making meaning of the zigs and zags of the stock market fascinated me to no end. I avidly read and absorbed all of the techniques to analyze stock charts, and there was a lot to learn. I remember being able to impress my dad and his buddies with bold stock market predictions based on technical analysis. When I was occasionally right, they sought me, the high school kid, to read this chart or that chart. All these years later, my dad still asks me to read the charts of his favorite stocks.
Technical Analysis: A Primer
There are two ways to analyze stock prices: fundamental analysis and technical analysis. Fundamental analysis uses metrics such as P/E ratio, earnings growth, dividend yield, and book value to calculate the intrinsic value of a company. Technical analysis uses none of that. In fact, most technicians could care less about fundamental analysis or even what the company actually does. It’s all about the charts.
By carefully studying the price charts, patterns can be identified, and the future can be predicted. Let’s give you a flavor of technical analysis and some of its techniques. (All charts courtesy of StockCharts.com).
# 1 Support and Resistance
Market technicians identify price levels where they believe a stock may make a bottom (support) or a top (resistance). These levels are often prices where the stock has bottomed or topped previously. For example, let’s look at the chart of GM, where I have added a support and resistance line:
Over the last three months of this chart, GM has consistently found support at the $35 level and resistance at the $38 level. A market technician would advise traders to buy at $35 and sell at $38, which would have been very profitable over this time period.
# 2 Moving Averages
Previous tops or bottoms are not the only levels used by market technicians to identify support or resistance levels. Moving averages plot the average prices of the past 50 or 200 trading days. These plots are overlaid onto the existing price chart. Moving averages can often be used to identify support and resistance levels. Here’s a stock chart of Ford (F), with its 200 day moving average:
As you can see from the chart, Ford has frequently made tops and bottoms off of its 200-day moving average.
# 3 Chart Patterns
Market technicians have recognized hundreds of different chart patterns that attempt to predict future stock prices. For example, a flag pattern occurs when a stock that is trending higher stalls, bouncing from support levels to resistance levels. When a flag pattern forms in a rising stock, you should buy because the stock is about to break out of its holding pattern and explode higher.
There are hundreds of other concepts, indicators, and charting overlays that technicians use to predict the future, but hopefully this gives you a flavor of how technical analysis works.
The Random Walk: A Realization
As part of one of my finance classes in college, I made an Excel spreadsheet which plotted stock prices as a random walk, the model most frequently used in academic finance. By assuming an expected return and standard deviation, I could use a random number generator to create simulated stock charts. Here is an example of a simulated stock chart.
When I looked at this chart, the technician in me immediately started to analyze it. Where are the support and resistance levels? Are there any chart patterns I can identify? Is the 50-day or 200-day moving average helpful in identifying support and resistance? Most importantly, which way will the chart move next?
Indeed, all of the technical analysis techniques I described above, including support and resistance, moving averages, and chart patterns, could be used to argue which way our simulated stock would move next. Of course, none of these techniques could actually work, because the chart was created using a random number generator. But doesn’t it look like a typical stock chart?
How about this simulated chart?
Or this one?
Today, I am a firm believer in the value of a simple, three-fund portfolio of index funds. Technical analysis is fun to read about, but it plays no part in how I invest my money. These days, when my dad asks me to analyze his favorite stock, I still try to humor him, knowing that my elaborate analysis will no better predict the future than the fortune teller on the street corner.
What do you think? Do you think money can be made with technical analysis? Why do so many people believe in it? Comment below!