Technical Analysis: A Chart-Heavy Technique To Identify Short-Term Investment Opportunities

8 mins

Technical Analysis: A Chart-Heavy Technique To Identify Short-Term Investment Opportunities

Things might get a little weird in this pack, so bear with us. We’re going to talk about something that all professional traders are aware of, but many longer-term investors ignore or even ridicule: technical analysis (TA). 

Why is it controversial? Because technical analysts say that past trading affects future movements – that market patterns repeat, driven by the psychological reactions of traders. This runs counter to academic theories (known as the efficient market hypothesis) that investors can conclude nothing from the past, and that only new information affects market prices. Efficient-market proponents argue that all publicly available information will already be incorporated into prices – and what could be more public than past trading patterns?

But what even is TA? TA says that past trading offers insight into the psychological state of traders, and can be used to make predictions about the future. For example, the fact that lots of people suddenly sold a stock last time it reached a certain price suggests it might happen again. Technical analysts have developed dozens of different indicators that aim to highlight the most opportune moments at which to buy or sell.

Because TA is solely concerned with price movements, not anything fundamental about a security – such as a stock’s valuation compared to earnings, or increasing demand for oil – it can be performed on anything with a price: stocks, gold, currencies, tulip bulbs, whatever.

Why should I care? If you’re just planning on investing in stocks or bonds and holding them for years, you probably don’t need to worry too much about TA. At best, it gives only short-term signals. If you’re planning to trade actively, however, you very much need to be aware of technical patterns – if only for the reason that most of the people you’re trading against will be watching them. 

Technical analysis is everywhere in the markets. Almost every investment bank in the world employs professional technical analysts, who between them publish dozens of research reports every week for high-paying clients. And pretty much every trading platform – whether something fancy like a Bloomberg or Factset terminal or just basic day-trading software – offers TA tools. 

So do I need to learn all these weird patterns? Not at all! But it’s still worth being aware of something that’s so widely used – and which might affect the short-term price of your investments. And if you’re considering trading actively, then you definitely need to do a bit of TA research (even if you think it’s hogwash) because so many others in the market will be using it to look for trading signals.

In fact, research has shown that – for time horizons of less than a week – TA trumps fundamentals when it comes to influencing trading decisions. And even those who are investing for the longer term may use TA – either to check whether their fundamental analysis is correct, or to work out the best time to enter or leave a long-term trade. 

How many traders use TA? A lot. Research has found that more than 90% of short-term currency traders use TA – though that figure varies across asset classes and is impossible to quantify exactly. Technical analysts, however, would argue that we all use TA subconsciously. Even if we’re not aware of why we decide to sell a currency or stock at a certain price, we’re (irrationally) influenced by things like the price we bought it for and the way it’s traded in recent days.

There are dozens and dozens of different signals that technical analysts use, with often outlandish names. To give you a flavor, let’s kick off with candle charts: one of the oldest forms of technical analysis, first developed by Japanese rice traders more than 300 years ago.

What’s a candle chart? Instead of the simple charts you’re probably used to, which draw a line between the end-of-day prices of stocks or bonds, a candle chart plots the price at the start of trading, the end of trading and the day’s high and low in one diagram. The open and close form the body of the candle, and the intraday high and low form the shadow or wick

Chart

Green (or sometimes white) candles show that the price rose that day, and red (or black) show the price fell. Importantly, a candle shows you not only whether a stock rallied or dropped on any given day, but what the trading patterns were during that day. 

Why is that important? Well, what if traders drove up a stock furiously before selling hard and pushing the price down below its opening level – only to buy again later in the day and thus leave the price almost unchanged at the close? You’d end up with a candle with a tiny body and long shadows. A TA proponent might say this signals indecision in the market, and therefore the possibility of a price swing coming. 

Technical analysts tend to examine sequences of candles (signifying several days of trading) to make bullish or bearish conclusions about future prices. They give these patterns snappy (some would say preposterous) names. This, for example, is a Hanging Man. It’s considered bearish in a rising market, because it shows the price falling a lot before recovering to close somewhere near the opening price. And perhaps that intraday selling is a sign of investor nervousness.

Chart

And this is an Abandoned Baby. Yes, really.

Chart

As with all technical analysis, the images are supposed to infer psychological clues about the mental state of traders from the patterns of price swings.

We’ve looked at candle charts. Now, let’s check out another common technical indicator: Fibonacci “retracement”. Technical analysts say that once a security (stock, bond, etc.) ends its upward climb and starts falling (or retraces), that decline is likely to end at one of several Fibonacci levels. 

What are those? OK, let’s start from the beginning. You may have heard of the Fibonacci sequence of numbers, set out by a 13th-century Italian mathematician, where the next number (after 0 and 1) is found by adding up the two numbers before it: 0, 1, 1, 2, 3, 5, 8, 13, etc.

Dividing a number in the sequence by the number after it always gives the same approximate answer: 0.618 (61.8%). Dividing it by the number two places ahead gives 0.382 (38.2%). And dividing by the number three places after always makes 0.236 (23.6%).

And so? Well, these numbers are related to the “Golden Ratio” found everywhere in nature and human design. And technical analysts think it can also be found in finance. If a rectangle that’s 61.8% as wide as it is long looks innately beautiful to us (a “golden rectangle”), then why shouldn’t the same hold for movements of markets?

So if a stock rallies from $100 to $200 before starting to fall again, TA suggests that the decline will end at the Fibonacci-inspired level of $176.40 – the $100 rally will naturally be followed by a retracement of $23.60, or 23.6%. If the drop breaches that level, a technical analyst would say $161.80 (38.2%) is the next price to watch, and so on. 

And exactly the same principles apply when a security rebounds in price after a selloff. There’s also a related theory that says a 50% retracement of a prior price move is common. Underpinning all these levels is, as always, the idea that human psychology imprints itself on price charts and the numbers on which they’re based.

Criticisms of technical analysis

For every trader greedily poring over complicated charts of Fibonacci levels, orphaned candles or moving averages, there are an equal number who think the whole thing is rubbish. 

Who? Proponents of the efficient market hypothesis, for example, claim that markets perform an effectively “random walk” and that nothing at all can be concluded from past price movements. And there are plenty of traders who dismiss technical analysis as a “pseudoscience” of hand-waving that draws grandiose conclusions from very limited data. Almost akin to astrology. 

But surely there must have been be studies? Believe it or not – even with so much money at stake – academics can’t agree on whether there’s anything to TA. Studies have alternately come down on both sides of the debate. 

Another criticism is more recent: in the modern day, when computers can be programmed to spot and act on as many technical patterns as you want to feed them – within milliseconds – can technical analysis possibly give an edge to a human trader? 

That being said, many people who are skeptical of TA will still keep an eye on the major signals, knowing that others in the market will be using them to make decisions to buy or sell. Sometimes prophecies can become self-fulfilling – and you have to go along with the crowd, even if you if you think it’s irrational. 

That’s it! We hope this pack on Technical Analysis has given you a flavor of this complicated topic. As always, hit us up with feedback. 

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Disclaimer: These articles are provided for information purposes only. Occasionally, an opinion about whether to buy or sell a specific investment may be provided. The content is not intended to be a personal recommendation to buy or sell any financial instrument or product, or to adopt any investment strategy as it is not provided based on an assessment of your investing knowledge and experience, your financial situation or your investment objectives. The value of your investments, and the income derived from them, may go down as well as up. You may not get back all the money that you invest. The investments referred to in this article may not be suitable for all investors, and if in doubt, an investor should seek advice from a qualified investment advisor.

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