[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!
This started building as an antithesis to Malkiel’s chapter on technical analysis but then comfortingly ended up at the same conclusions. He did the same random number generator experiment and duped a few technical analysis guys. I don’t know if I’d go to the extreme of not eating dinner with a technical analyst as he does, but it’s good to see you reinforce the same ideas and fold in your personal experience. Thanks!
Almost had a heart attack reading this, until I got to the reveal. Thank you!
Nice attempt at trying to describe technical analysis, but a bit of a miss. It actually makes my blood boil with how often technical analysis is improperly described. Those that use technical analysis successfully do not use it predict markets at all (which I agree is completely impossible). Technicians use such analysis to pick their entry and exit points in order to manage risk and find positively skewed risk/reward opportunities. Again, using technical analysis has nothing to do with predicting where a market will move next. We don’t care about that. We just need some indicators, or points on a chart, where if the price moves to it, we admit we’re wrong, take the loss, and move on. For example, in your first chart, momentum breakout traders would set a buy at $38.5, but a stop loss exit $35, for if the market moves below $35, the trade sours, and the small loss needs to be taken. But because markets have been proven to exhibit momentum and serial correlation more often than a statistical normal distribution would suggest, also have statistical kurtosis (“fat tails”), and experience bubbles and crashes, this market may move to $100 or beyond, no one knows! And if it does trend in large way, technical analysis could have been used to capture the move. Again, it is used to manage risk and to overlay on top of markets in order to capture positively skewed profit potentials. It is not used for prediction purposes at all. Traders don’t care which individual trades will be the winners or losers; they just want to know the distribution of the payouts.
I too generated “random walk” excel outputs in college, but added in the ability for market prices to have fat tails/trends/momentum in order to make it more realistic. Hint: that small change makes all the difference in terms of whether or not techincal analysis “works”. I’ve been a registered CTA/CPO trading commodity markets for clients ever since (almost a decade). My wife is a doc which is why I read Jim’s blog.
That is ridiculous, technical analysts always say they are using the indicators to control risk and have entry and exit. The problem, is that it is all random. Lets say you will buy if the stock price breaks the 200d MA and sell if it drops 10% below it just to keep it simple. You will just get chopped up to pieces over and over and over again. Will you catch a trend once in a while? Of course, obviously for a stock to go up it has to break the 200MA. However, that “big trend” does not always pay for all the “little losses.” Plus the tax situation is horrendous since you are selling all the time. Plus you manage to constantly buy high when the market breaks out and then when it goes through normal volatility and hits your sell point, you locked in a loss, and then most of the time it just goes back up again and you do this over and over and over again, you will get no where. Just because a stock breaks a MA or a previous low indicating a break in structure, that means nothing, it usually goes right back up. You would be better off BUYING when it gets low like that not selling.
Trend following and technical analysis is just a marketing scam. It was created to give ignorant people the illusion that they can get 20% and more returns consistently just so technical analysts can sell $3000 courses to the naïve public. The only money in technical analysis is selling useless courses on how to do it…resembles a Ponzi scheme.
The suckers that pay big named hedge funds that claim to do technical analysis and make them a killing always under perform the market. Hedge funds don’t make money using technical analysis. They make money off the idiots buying into it and taking a 2% fee and 20% profit.
Like most things in life, if you could easily make 20% or more per year doing some simple technical analysis, you would not need to sell courses on how to do it or try to teach people. That is bull. You would just mind your own business, trade on your own and make billions and billions of dollars. The whole thing is a scam.
I spent 3 years of my life doing NOTHING but technical analysis (except medicine, but in my mind was always on technical analysis and was even trading between patients). And no I was not doing it wrong and I am not stupid. All I have to show for it is a huge net loss on my account I will never get back and probably a gastric ulcer.
Interesting: “I was not doing it wrong and I am not stupid. All I have to show for it is a huge net loss on my account I will never get back”
Perhaps you may try trading longer term (i.e. Not between patient visits), keeping losses smaller and being more patient with winning trades. You may be surprised with what you find!
Well Technical Trader, why don’t you school all of us and prove your superiority by telling us exactly what your trading system is. What you buy, what indicators you use, everything. Then we will believe you once we all start getting consistent double digit returns.
So go ahead master, please teach us so we can be a believer
Sorry, I don’t teach. I’ve found that a losing trader can do little to transform himself into a winning trader. A losing trader is not going to want to transform himself. That’s the kind of thing winning traders do.
My main point is simply that 1) Successful technical trading is not actually predictive in any way; instead it is a mathematical expectancy exercise that responds to the ever present moment of now. 2) Because markets are driven by non-random fundamentals, in addition to the fact that price moves are often accentuated by irrational market participants’ emotions, prices can exhibit momentum/fat tails/outlier events. And so a technical analysis strategy that trades breakouts, cuts losses, rides winners, and has sound money/risk management can be profitable.
You are funny…[ad hominem response deleted]…You are the same as every other scammy technical trader. Big hat, no cattle. All talk, never any proof. Just unrealistic theoretical nonsense to make yourself feel superior….[ad hominem response deleted]…
You aren’t fooling anyone. I understand by you regurgitating the phrases of big time hedge fund managers like “buy breakouts, cut losses, risk management” makes you think you sound so elite but we know you are just a …[ad hominem response deleted]…
“can be profitable.”
Hard to disagree with that. Of course, it could also be phrased “may not be profitable.”
Nice to see an another profitable trader here. Nice post which I 100% agree.
This is a clear description of charting basics. I think some advanced investors combine their understanding of market history, market psychology, fundamental investing, and technical skills. Charting can be helpful when looking at large trends like secular bull markets etc. But should we trade based on that? nope. Should we buy and sell stocks based on that? nope. I don’t know anyone who profited above the market return using charting- at least for the long haul. The amazing part is these very chart patterns are analyzed by “experts” on TV everyday. Humans have a compelling need to see patterns where they don’t exist.
+1!
I used to follow a few sites that preached this back during the dot com days. They never seem to post their results though. Hmmm.
There is the John Hancock Technical Opportunities fund with a glowing 2.11% return over the last three years. I guess they didn’t say it is a good opportunity. Nice article WSP.
Wow, WSP. What a beautiful article! You made an important distinction that everyone should know. And you made it simple and easy to understand.
To me, it appears this superficial volatility makes so many news (like your post about the financial news on your site), it unnecessarily complicates and obfuscates what should be simple and boring.
Reminds me of Warren Buffett’s line “I realized technical analysis doesn’t work when I turned the chart upside down and got the same answer.”
Three fund portfolio is the way to go. Set it and forget it! Takes out the random guess work.
Just because a randomly generated chart can be made to look like a real chart doesn’t mean TA doesn’t work. There is some psychology behind real charts which seems clear from behavioral finance. Most people though expect too much from TA. It is not a crystal ball. It gives me only a 5% advantage. Keep it simple and find a few indicators you know well, just like prescribing meds. 3-fund portfolio is great too, is part of my core strategy, and much less effort for most people.
Hi Jason,
Even 1% advantage would be great to have. Can you point to a few resources?
You can increase returns with tools like MACD, short vs long MA, RSI. Start here: http://www.stockcharts.com/school/doku.php?id=chart_school
Check out the classic Edwards and Magee, Technical analysis of stock trends. Also The Disciplined Trader by Mark Douglas because TA is not helpful if you have bad trading habits. Best wishes!
Yes I used to try to do this also. I had a subscription to Investors Business Daily and would study the charts and the fundamentals. It is a lot of work. I just buy indexes now. So much easier.
There is a third alternative that I call business analysis. It is much harder to do since you actually need to understand the business and its leaders. You also need to carefully evaluate what you expect from your investments since someone such as me who needs current income in retirement is much different from someone who is still working and might want stock price appreciation over time. Good topic since many don’t understand technical analysis and its many limitations.
Just wondering how much has changed since I saw this Jan 2014.
Portfolio 150: The White Coat Investor Portfolio
17.5% Vanguard Total Stock Market Index Fund
10% TSP S Fund
5% Vanguard Value Index Fund
5% Vanguard Small Value Index Fund
7.5% Vanguard REIT Index Fund
5% Bridgeway Ultra Small Company Market Fund (BRSIX)
15% Vanguard Total International Stock Market Fund/TSP I Fund
5% Vanguard Emerging Markets Index Fund
5% Vanguard International Small Index Fund
10% Schwab TIPS ETF
10% TSP G Fund
5% Peer 2 Peer Lending Securities (mostly Lending Club)
WCI wrote an update of his asset allocation in this article from March 2017.
https://www.whitecoatinvestor.com/the-new-wci-asset-allocation/
https://www.whitecoatinvestor.com/the-new-wci-asset-allocation/
How did Warren Buffet make his fortune? What sort of analysis was he using when he was deciding to buy into a certain company?
Warren Buffett uses fundamental analysis — his mentor was Benjamin Graham who wrote the seminal book on fundamental investing, Security Analysis.
https://www.amazon.com/Security-Analysis-Foreword-Buffett-Editions/dp/0071592539
Buying a large long term stake in a company is much different that what almost all of us on this site do. You have little to no input to management, you vote but have little to no leverage. Buffet on the other hand has massive leverage and in some cases actually is management.
I might encounter some resistance, but please offer me support as I provide a technical analysis of my approach to investing.
I’ve found that on alternate Wednesday when the moon is waxing gibbous and I’ve run out of Head and Shoulders, if the power’s gone out and I’m reviewing my charts by the light of a candlestick, that my portfolio is bound to do… something.
Except when it doesn’t. But as a chartist, I’m sure I’m bound to strike it rich soon. I’ve been reading the tea leaves and examining goose droppings long enough that I’m sure to outperform Buffett once they let me out of this padded room. For reals.
P.S. If the sarcasm of this post is lost on you, please name three billionaires who made their wealth through technical analysis. Yeah, I couldn’t think of any either.
John Henry (owner of the Boston Red Sox), Paul Tudor Jones, and Cliff Asness to name “just” three of the billionaires…and there are 50-100 who are worth “just” hundreds of millions. All using tehincal analysis as a risk management tool to help create asymmetric, positive-skew, trading payouts and capture the large market trends across various markets. No prediction, just math, and positive expectancy.
Technical Analysis absolutely works.. those that don’t understand it are just too lazy to put in the work..
3 fund portfolio is great for trending markets, but when you lose 50% of ur portfolio in the next recession like 2008/2009 and 2011 you’ll wonder how you could have spotted when to get out and get back in..
We’ll always disagree on the value of technical analysis, but I agree with you that the bull market of the last 8 years has been a major reason for the accelerating popularity of index fund investing. When we have our inevitable correction, investors will start flocking to “stock picking” and “swing trading” strategies. I think that will be a mistake.
Or just too unlucky. Hard to tell the difference between skill and luck some times.
Trend following does in fact work, but across markets as a whole and not individual stocks. This is related to momentum, which the very much evidence-based Fama and French called the premier anomaly. The following link is a comprehensive back test of trend following across most financial markets of the world, demonstrating effectiveness not so much at increasing gains but rather minimizing losses, which trend following aims to do.
http://www.philosophicaleconomics.com/2016/01/movingaverage/
I agree that a simple moving average applied to broad market investments has been a halfway decent way to invest given momentum. Whether that continues in the future or not, I have no idea.
Re: YoungInvestor — in my opinion, backtesting in finance = retrospective research and should be treated as such.
I have never seen a chart that looks like either of those.
actually upon further analysis I see the author admit he artificially created a price trend in the data by including an expected return and ensured the trend was obvious by including a standard deviation variable.
if you do that, of course it’s going to be receptive to technical analysis because markets are moving most of the time and that means trending. if the chart was actually random there would be an extremely high or low number and you would not be able to see any other action on the chart.
You could test if your randomly generated charts behave in the same way as stock charts. They probably won’t have Elliot waves and stuff like that.