Technical Analysis and Filters
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Technical Analysis, or "TA", is simply the study of price charts. A "chart" is a graph that shows a progression of relevant price data. People study price charts with the intention of finding and implementing investment strategies based on chart patterns that repeat, in order to take advantage of a move that happened before and - hopefully - will happen again in the future.
The study of TA is the study of a chart, and specifically patterns on that chart that happened before and could happen again. The name of the company, what the company makes, where it is located, how much money it makes when it sells its products, none of these things hold the slightest interest for the TA chart reader. The underlying premise of TA is that the price that is being graphed on the chart has already discounted all fundamental data. In other words, there is no reason to study any FA because all the fundamental data about whatever you are interpreting has already been "built in" to the price chart you are looking at. A "pure" technical analyst cares nothing about fundamental data.
There are many different kinds of TA, and for every kind of TA there are a multitude of ways to interpret the price chart. The best single book I've ever found that discusses traditional price chart patterns and gives concise and understandable explanations of them is Technical Analysis of the Financial Markets by John J. Murphy. You should own this book as a reference, but keep in mind that there is a difference between describing a chart pattern and interpreting why it has formed or what will happen next. Just because John Murphy says it’s true does not mean that it really is true. This is not the only book that describes traditional chart patterns; there are dozens of similar books.
To many people, TA is nothing more than voodoo. Many people believe TA “works” (when it works) simply because it is followed by traders, the traders have to make sense of the market, and the mere application of TA among a group of people that are doing the same thing forms the basis for its occasional workability. In other words, those that do not believe TA works assert that it is a meaningless activity; that TA aficionados make TA into a self-fulfilling prophecy simply by applying it.
Someone who does not believe TA has any relevance will tell you that he can show a chart to ten different TA analysts and each will give him a different interpretation of that same chart. This is very close to the truth. If a very successful method of interpreting charts were public knowledge, the game of interpreting charts would be over! There is also a theory that the markets have no trends, and there is no way to understand what is happening in the stock market. This is called the “Random Walk” theory. It is nonsense, but good, because some people believe it, and we want their money.
You should understand three basic things about TA for it to be of any use to you. First, it does exist, it is a very wide field of study, and some forms of TA are quite valid. Secondly, if the majority of the people that make investment decisions using TA are doing the same thing and following the same chart or the same signals, the market will certainly go a different way. It has to, to even things out, just by the nature of supply and demand! Thirdly, it is very easy to let the study of TA consume you. It is easy for some people to get so caught up in analysis of a chart that they lose their grip on reality. Simply stated, there are quite a few nutbar TA people.
The one thing about Technical Analysis that is agreed upon by almost all technical analysts is that "nobody understands why" the chart patterns form. It is evident that almost all technical analysts don't care why chart patterns form. The simple fact that patterns form is all that is necessary for the technical analyst. Trying to understand why chart patterns form appears to be antithetical to the traditional concepts of technical analysis - that is, why chart patterns form is Fundamental Analysis!
Also, interpretation of charts almost always involves math, many times rather complex math. You could ask 100 chart readers what Welles Wilder's Relative Strength Index is, and many of them could tell you it's a wavy line that they call "RSI". Some could tell you it's a "filter" - something that weeds out things you want to look at more closely. Few could tell you what RSI measures, or how it is calculated. Very few indeed could show you a workable signal using RSI that Welles Wilder didn't think of before he wrote his book.
Thankfully, it is not necessary to understand the math involved with a filter like RSI in order to figure out if it it helpful or not - but if you follow someone else's explanation of it, it would be wise to ensure that they understand it, otherwise you are listening to the advice of someone who does not understand what they are talking about. |
