On Charting

When it comes to technical analysis, there are two extreme schools of thoughts. The first group are the pure technicians, who regard fundamentals as unnecessary information that is ultimately discounted in a stock’s share price. The other group are the pure fundamentalists who only believe in data in the balance sheet and disdain chart analysis as something akin to reading tea leaves. In my opinion, price charts are very useful, but they are not as magically predictive as some chartists claim.

Just like a drop in barometric pressure signalling a coming typhoon, or a thirty-eight degree Celsius of body temperature indicates fever, price charts enable the readers to measure the emotions of the buyers and the sellers in the marketplace. It is people who make buy and sell decisions, which are often coloured with expectations on the future direction of price. The chart captures their mental states in terms of price and volume change, and illustrates the verdict of supply and demand in a visual display. As William O’Neil (2009) puts it:

“X-rays and brain scans are pictures which doctors study to diagnose what is actually occurring in a human being. EKGs and ultrasound echo waves are recorded on graph paper or television-like terminals to show what is happening to the human heart. Maps are plotted and set to scale to help people tell exactly where they are and how to get where they want to go. Seismic data is traced on charts to help geologists study which structures or patterns seem most likely to contain oil. Economic indicators are plotted on graphs to assist in their interpretation. The price and-volume history of a stock is recorded on graph paper to help determine if a stock is strong and healthy or if it is weak and behaving in an abnormal fashion.”

Human nature does not change. Share prices move in virtually the same fashion today that they followed in the past. This provides a solid basis for the chart reader to make intelligent decisions. Of course, some people complain that they cannot make sense of it, which is understandable. If you are not a medical professional, you cannot make sense of the EKG and MRI patterns in a hospital room either. But to a trained professional, this could be valuable information to tell whether the body is functioning normally. Similarly, in examining the price and volume on a chart, a trader can tell whether the price is acting normally or not.

Mark Minervini (2013) has an excellent analogy of this:

“Suppose you take the 6:05 train to work each morning. It generally arrives at the station somewhere between 6:00 and 6:10. But today, you look down at your watch and see that it is 6:15 and the train has still not arrived. You don’t think much about it and probably say to yourself that the train is just running a little late. What happens at seven o’clock if the train has still not pulled into the station? You are most likely going to think that maybe something is wrong with the train; the more time that elapses, the higher the probability that something has gone wrong. The only reason you can make this educated guess is that you have knowledge of what is normal and what should happen.”

However, some so-called “trading coaches” like to exaggerate the power of price charts. Very often, those are people who have never had any success in the stock market. Since they make a living by selling charting services and seminars, they like to hype chart-reading as a supernatural fortune-telling skill. It goes without saying that it is nonsense. Chart patterns are not the cause of why the price moves. They simply reflect the underlying emotions of the buyers and seller. Even though people are inclined to similar behavioural patterns, it is by no mean a sure-fire crystal ball which could tell the future.

In my opinion, a price chart is useful in three areas. Firstly, it helps me to determine whether a stock is under accumulation or distribution (or, being bought or sold in great quantity). It helps me to find candidates which are already under a prevailing uptrend (or under demand by the institutions). Secondly, it helps me to time my entries at a time when the downside risk is limited but the upside potential is abundant. Finally, it helps me to judge if I sell a position if the price and volume does not act right on the chart. 

The price chart is a very useful tool for traders, but it is only true when it is understood correctly. It is useful in identifying the current trend of the market, and also seeing whether the present moment is a good time to buy. Do not have unrealistic expectations that you can find some magical chart patterns of Holy Grail indicators which can make you a fortune in a short time. Those are just sales pitches of failed traders who make money out of you rather than the market. Just like doctors studying EEG and MRI, good chart-reading takes a lot of practice and hard work to excel.

REFERENCE:
Minervini, M. (2013). Trade like a Stock Market Wizards: How to achieve superperformance in stocks in any market. New York, NY: McGraw-Hill Education.
O’Neil, W. J. (2009). How to Make Money in Stocks: A Winning System in Good Times and Bad (4ᵗʰ edition). New York, NY: McGraw-Hill Education.