Hi gang,
Yesterday we held a free online seminar at Teach Me to Trade. One section of it presented by David Bush dealt with the question: "Why use technical analysis?" Since this thread deals intensely with T/A I feel it would be beneficial to repost that section here. I hope you enjoy!
All my best,
Toni Hansen
Why Do We Use Technical Analysis?
This is a fair question. An Important one
We believe that it is essential to successful trading to understand perhaps the most fundamental premise underlying Technical Analysis, and it is this:
Everything known about each and every stock (or commodity, index, etc),
or anticipated to be a known fact sometime in the future, is already reflected in the price chart of the stock in question. This is important for reasons we’ll see shortly.
In other words, if WXYZ Corp. is expected to have revenue shortfalls and excess inventory for the next three quarters,
this expectation is already written into the stock price.
Therefore, these expectations are already apparent in the price chart of WXYZ.
This is why the stock market is commonly referred to as a "discounting mechanism."
To understand why this is, think about what’s at stake in the stock market.
Each and every day, the world’s largest financial institutions’ trading desks, pension funds, hedge funds, mutual funds, and individual, independent market participants show up to stake their claim in the open marketplace and in most cases attempt to out perform each other. Each entity is looking for an edge in the market.
It is for this reason that common sense rarely applies to the stock market.
Take this example. ABDC Inc. releases earnings data showing their worst loss of revenue in the company’s 20-year history after the closing bell.
The next morning, ABCD gaps up and gains $4.50 to mark its biggest winning day in 6 months. Most investors think --and rightly so-
"How could this possibly be? Did everybody hear the news wrong? I mean, this was BAD news! Why did the stock rocket higher? It doesn’t make sense!"
Ahhh…the danger of common sense.
The real fact is that ABCD Inc.’s dismal quarterly earnings report was anticipated as much as nine months ago,
and by no accident that is when the stock began a steep downtrend.
By the time of the actual poor earnings report, the shortfall had been completely discounted, entirely factored in to the price of the stock.
So instead of performing terribly after the report, ABCD gains handsomely.
Why? The bad news is old hat, and there are no more aggressive sellers with future expectations of more shortfalls, only the expected bad news, so the stock rises.
Technical analysis does not rely on common sense.
It simply displays in graphic form each and every trade made by each and every individual or institution second by second, minute by minute, day by day.
Therefore, by definition, each chart displays the expectations of these market participants far in advance of the actual realization of the expectations.
This is where ideas about a company’s business and the stock of the same company often part ways.
Technical analysis helps us see what is actually happening to the investment vehicle itself, not solely to the company’s business itself.
That’s why we use it. The charts show the facts.
Now that we’ve briefly explored one of the underlying principles of technical analysis, let’s tale a look at how we apply it on a daily basis.
As we have already said, price charts are a record of all trades, and therefore of the expectations of those making them.
It is a logical deduction then to say that price charts are a refection of human nature.
This sounds loftily philosophical, but it is actually quite practical,
and something we use each and every day in our Advanced Chat Room.
Think about buying a car. Before any of us shell out $30,000 or more for a new buggy,
we walk around it, grill the seller with question after question, and take it out on the road for a test drive.
Only then are we willing to make the commitment.
So it is human nature to expect the same seemingly smart, thorough strategy to work in the stock market.
But requiring "proof" in the market means buying only once the value of a stock becomes obvious to all. In the market, this means buying too late.
Most traders wait for a stock to become obviously attractive,
and this means that it has already gone up. "Hey, it’s going up…it must be good… I’ll buy it." The longer a trader waits, the more it goes up, and the greedier he/she becomes.
So greed shows itself at tops, after the move is obvious,
when everybody and their uncle wants it.
This greed typically shows up as a wide range candlestick following several prior days
(or periods) of gains.
A spike in volume will frequently also accompany this range expansion bar,
telling the educated chart reader that the recent gains in the stock have been talked about
at every water cooler on every floor of every office all over the world and therefore has now become obvious to all.
By the very nature of wanting what everybody else wants,
greed sets in and everyone rushes to buy at the top.
We see this simple yet profound dynamic played out repeatedly in all timeframes of charts,
and use it to our advantage by either [1] selling our now very valuable merchandise to those who will so desperately pay any price to acquire it,
[2] sell short to the anxious buyers in anticipation that since the move is obvious to all there will be no more buyers to follow,
or [3] simply avoid buying blindly with the stampeding herd after such rampant greed has set in.
It’s all in the charts.
And in a nutshell, that’s why we use Technical Analysis…to see the facts,
and play them accordingly.
To trade the patterns, not hearsay.
And to act based on what IS, not on what we hope…some day…will be.
Technical Analysis helps us achieve that aim.
