Why Technical Analysis Matters

There’s a very straight forward discussion of technical analysis in the Online version of Barron’s, by Technician Michael Kahn. He outlines the three basic goals of TA as a tool:

• Seeing where the stock is currently trading and figuring out how it got there. (using trends, support and resistance levels).

• Determining the power of a trend (as well as signs of a pending end of a trend). Includes Technical concepts as trading volume and momentum.

• Making comparisons of the stock to the market, its peers in its own industry and even to its own history. (relative performance and moving averages are covered here).

Kahn also delivers a checklist of key technical tools:

Trends and trendlines: There is no secret to finding a trend. If prices are generally rising and making higher highs as well as higher lows, then we have a rising trend. We want stocks that are in rising trends.

Support and Resistance:  These are terms that simply tell us what price levels are likely to bring out the buyers (demand) or the sellers (supply), respectively. What we want to see is a current price that has either just moved through resistance (demand overwhelmed supply) or one that is far from the next resistance level.

Moving Averages: Moving averages, or simply price averages, are just average prices over a user-defined period of time, usually 50 or 200 days. They help us determine if a trend is turning, as prices cross the averages. We are looking for price to be above selected averages but not too far above them.

Volume and Momentum: These two indicators confirm the health of a trend or warn of an impending change. Is buying spreading to other investors, as evidenced by rising trading volume? We also want to know if days when prices rise outnumber and result in bigger price moves than days when prices fall (momentum). If either volume or momentum starts to fade, then we can surmise that the trend is weakening.

Relative Performance: Relative performance charts simply divide the price of a stock by a relevant market index or industry group. The theory is that we should buy strong stocks in strong sectors and this is how we find them.

Lastly, the series shows how to put the theory and tools to work. The author gets specific about the process of morphing from a "stock idea" to an actual buy or sell decision:

1. Look at the trend. We want a rising trend or one that is just starting to do so.

2. Find nearby support and resistance levels. We are trying to find stocks where demand exceeds supply and new supply is not likely to develop soon

3. Determine if the current trend is healthy. We want prices to be above a relevant moving average but not so far that the stock is prone to a snapback decline as profit taking sets in.

4. Check volume and momentum indicators to be sure that they are not fading as the stock price rises. A falling indicator warns that there might be technical problems before price action sours.

5. Find out if the stock is leading a benchmark. Is the particular stock at least matching the performance of the market and its peers?

6. If the stock passes all these tests, we have a candidate for purchase.

Its a good two part article, well worth reading . . .


Why Technical Analysis Matters
Michael Kahn
Barron’s, MONDAY, NOVEMBER 6, 2006   

Putting Stocks to the Technical Test
Michael Kahn
Barron’s, MONDAY, NOVEMBER 13, 2006   

What's been said:

Discussions found on the web:
  1. Carl commented on Nov 19

    Technical Analysis, as discussed in this article, in my opinion, has not evolved much in the last 20 years or so, which is surprising considering the growth of the PC industry and the powerful tools that have been distributed into everyone’s home.

    We think that Technical Analysis will soon see a new period of evolution.

    With the enormous growth of the electronic futures markets, it is our opinion that the next stage of development for Technical Analysis will be the study of how Program Trading effects the immediate movement of price within the futures markets.

    The early days of Technical Analysis software where Price Momemtum, Stochastics, etc., were key values, will be replaced over the next decade by software that can read the footprints of massive program trades and can determine, in real-time, whether these programs trades are making a good or bad bets, and if the bet is good, whether a fund should piggyback these trades.

    Actually, this future is here now. This next period of Technical Ananlysis evolvement has already begun.


  2. TBP Troll ‘bot commented on Nov 19

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  3. curmudgeonly troll commented on Nov 19

    Bruce Kovner – Fundamentalists who say they are not going to pay any attention to the charts are like a doctor who says he’s not going to take a patient’s temperature.

  4. muckdog commented on Nov 19

    The Holy Grail.


    Great link, and good columns by Kahn. Of course, it’s easier to look at a chart in retrospect and see what one should have done, than to look at the right edge of the chart and try to predict what’s going to happen next. And even with tools (charts, PCs, etc), one has to still make decisions and deal with any emotions (ego, indecision, fear, greed, etc.).

  5. cm commented on Nov 19

    The reason that TA works is that it creates group dynamics with positive feedback. Patterns happen because “technicians”, and those following their advice or trading by technical indicators, make them happen.

  6. cButler commented on Nov 19

    Michael Kahn mostly exemplifies what’s erroneous in TA, with his unending use of really silly metaphors and similes like “what goes up must come down”, and “if you throw a ball up, it eventually loses energy….”, as well as claims that a non-confirming RSI at a high equivalates to a measure of a “car running out of gas”. And on it goes. Really, does he believe the market moves relative to a physical mass exerting gravitational pull towards its centre, with the 0 line on your chart being the surface of that body? It all reads like “Dick and Jane Do TA”.

    Those interested can read my piece about Mr. Kahn at http://ibexsalad.blogspot.com/search?q=races

  7. mentalmodel commented on Nov 19

    Here’s a quote from the academic literature about TA:

    “One explanation for this state of controversy and confusion is the unique and sometimes impenetrable jargon used by technical analysts, some of which has developed into a standard lexicon that can be translated. But there are many “homegrown” variations, each with its own patois, which can often frustrate the uninitiated. Campbell, Lo, and MacKinlay ~1997, 43–44! provide a striking example of the linguistic barriers between technical analysts and academic finance by contrasting this statement:

    The presence of clearly identified support and resistance levels, coupled with a one-third retracement parameter when prices lie between them, suggests the presence of strong buying and selling opportunities in thenear-term.

    with this one:
    The magnitudes and decay pattern of the first twelve autocorrelations and the statistical significance of the Box-Pierce Q-statistic suggest the presence of a high-frequency predictable component in stock returns.

    Despite the fact that both statements have the same meaning—that past prices contain information for predicting future returns—most readers find one statement plausible and the other puzzling or, worse, offensive.”

  8. PC commented on Nov 19

    I think there are two types of TA. The first type of TA attempts to predict markets and are used by nearly all newsletter writers to sell subscriptions, e.g. Prechter and his Elliot Wave predictions. I recall at the beginning of 2006, all the well known TA practitioners came out and proclaimed that the cyclical bull market was closed to being over and the markets would decline into a four year cycle low in the second half of this year etc. etc……Boy are they wrong.

    Another great example I remember was Peter Eliades back in late 2002 on an interview with Ike Iossif. Eliades said based on a proprietary indicator of his and based on his two decades of TA experience, there is “no way” the stock market had bottomed out in Oct. 2002. He went on to say if the market had indeed bottomed, he would “no longer hang out his shingle” as a TA practitioner (to quote him). The market bottomed out in Oct. 2002 and Eliades is still around selling his newsletter.

    The smart ones, having been burned in the past, will hedge their bets and make things very vague. I respect Richard Russell greatly but he is an old fox. He has been bearish (and wrong) and in T-bills for a long long time but when he is wrong, he would cite his Primary Trend Indicator as bullish and said he don’t want to play the market. That’s nearly 3 years ago and over 3,000 Dow points ago. He would have been fired if he was a fund manager.

    Anyway I have diverged, this type of predictive TA is mostly useless and indeed harmful in trading markets, IMO.

    Another type of TA, used by people like Richard Dennis, does not seek to predict markets. Instead they come right out and say they don’t know where markets are headed. Instead they use price action to define trends and they trade and “react” to these trends accordingly. Far less sexy as you cannot claim special powers in predicting markets. But this tyep of TA is the way to make money in markets.

    Just my two cents worth. By the way I consider Kahn in the same category of predictive TA but heding his bets with vague statements.

  9. PC commented on Nov 19

    PS – How to judge good and bad TA? The more complicated the TA, e.g. using a wide array of indicators, and the more predictive it is, the more useless it is.

    Good TAs are simple and based mainly on price action to define trends. It adheres to the KISS concept – Keep It Simple Stupid.

  10. Philippe RAFAT commented on Nov 20

    The TA analysis is a useful support to the FUNDAMENTAL analysis of the INVESTORS in order to assess entry and exit points when fundamentals drive these decisions.
    I am affraid that there is now an “entertained “confusion of role, the TA drives the markets crowd and I am interested to see at this very young stage of the TA preeminence what will be the outcome (there are few tests sample 2005 bond market and 2006 stock market)

  11. Drew Yallop commented on Nov 26

    I just received and consumed in two days David Aronson’s newly published
    “Evidence-Based Technical Analysis” Wiley 2006. It is a revelation. It makes meaningless all the pro and con arguments for “subjective technical analysis”, his term for the vague, untestable propositions and untested tools advocated by most practitioners (including Kahn it seems).

    With impeccable statistical reasoning described in the most lucid and illuminating way he explodes all the myths. For anyone embarking on the technical path this reading is essential. Interestingly he is positive on the efficacy of TA but only if it supported by strict statistical testing of the evidence. This complicates things a lot because almost all popular TA ‘tools’ do not make the hurdle. What will make the hurdle is left undefined but there are clear suggestions on what is required to find that gold. Indeed some of it has probably already been found by the most sophisticated hedge funds.

    Many of the conclusions are counter-intuitive so be prepared to do some thinking. Particularly important is understanding how much random variations of a variable (i.e. luck) can make a useless predictor look good.
    He also demolishes EMT with arguments that are once subtle and clear.

    In fact, this book is not only a valuable TA resource but also will improve your critical thinking on all the BS that passes for information. What a relief to realize that most of the popular experts know nothing and can add nothing to financial decision making. Suddenly all the noise disappears; you are left with a bomb-proof set of mental and statistical tools with which to find the real meghilla.

    Anyone else read it?

    Drew Yallop

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