If you draw enough lines on a stock chart, one of them is bound to predict the future accurately! Given that technical analysis is perfect in hindsight and flawed in foresight, many investors mock it as arbitrary. Some, like Aaron Brown, link its practice with horoscopes, tarot cards, and crystal balls. 

The difference between science and voodoo is rigorous, systematic, skeptical testing. If by “technical analysis” you mean the standard charting dogmas, with constant exceptions to explain every missed prediction, it’s pure voodoo.- Aaron Brown.

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Technical analysis is one of many tools we use to manage clients’ wealth. While inconsistent, as with every forecasting model, it is the best means for quantifying investors’ collective behaviors. Simply, historical price and volume data provide a critical context for price levels likely to motivate buyers and sellers.

For more information on where technical analysis fits into our investment analysis, please read our article, Golf and Investing: Mastering Long and Short Games For Success.
 

What Is A Trade?

Individual transactions and the prices at which they occur form the basis of technical analysis. Therefore, it’s essential to start a discussion of technical analysis with a better understanding of individual trades and series of trades.  

Sometimes, media pundits say the market was up because there were more buyers than sellers. Or, the environment is bullish because there is cash on the sidelines. Such storylines are senseless.

Every single trade must have a buyer and a seller.

Even if there are hordes of buyers desperately wanting to buy a stock, no trade will occur until a willing seller sells.

A buyer may leave the proverbial sideline and spend his cash. However, the cash is instantly replaced by the seller, who is now on the sideline.

Given that each trade has a buyer and a seller, the determinant of price is the relative aggressiveness of the buyer versus the seller. For example, assume a stock last traded at $42.05; a buyer wants to buy it at $42.00, and the seller wants to sell it at $42.10. If the seller is anxious to sell and the buyer is indifferent, the seller may meet the buyer’s demand at $42.00, thus pushing the stock price down by a nickel. If more anxious sellers come to the forefront and the other buyers are also indifferent and sparse, the buyers have the ball. Thus, the price could decline further.  

The measure of intent of buyers and sellers on one trade is meaningless. However, the multitude of trades and their prices and volume over time helps us appreciate the collective behaviors of investors.

In short, technical analysis helps us identify the underlying behaviors, fears, risk tolerances, and a host of seemingly non-quantifiable traits of buyers and sellers.
 

What is Technical Analysis?

The following quote from market technician Richard Wyckoff helps answer our question.

The significance of price movements reveals itself only when compared to past price behavior.

He claims that context is everything. Comparing current prices to prior prices, volumes, and trends helps us appreciate the motivations of existing shareholders and better assess how they may react to current and future price movements.

Technical analysis tools include support and resistance trend lines, chart patterns, moving averages, volume analysis and a slew of formulaic indicators.

In this article, we walk through a few basic technical analysis methods. We do it to appreciate what they tell us about investor behaviors but not to teach you how to use them.

If you think there is value in using technical analysis, finding the trend lines, patterns, and indicators that you understand and work for you is crucial. They may change over time as market conditions change. Furthermore, you will find that some forms of analysis work well for some securities and are of little help for others.

While you can overwhelm yourself by following too many analyses, it is essential not to rely on too few. Using several different techniques can help confirm expectations or provide an alternative forecast.
 

Support and Resistance Trend Lines

Support and resistance lines are one of the most straightforward chart patterns to recognize. In our hypothetical graph above, the orange trend line is support and the green line represents resistance. A trend line connects a series of consecutive highs or lows, be it linear or curved. The points where the price meets the trend line often represent prices where investor behaviors are most motivated. Technicians consider a trend line valid if the price bounces off a trend line at least three times.

The orange uptrend line indicates buyers are becoming more aggressive about the price they are willing to pay for the stock. In this case, they are becoming more motivated to buy than sellers are to sell.

The flat green line shows that investors are willing to sell at $30, but their collective aggressiveness or motivation is not changing. The pattern is bullish as it points to more willingness of investors to buy versus selling.

The lines form a bullish wedge pattern. The highlighted circle is a second signal that buyers are more aggressive than sellers. In this case, the price started increasing before it reached support. That is potentially a sign that buyers’ relative aggressiveness may be increasing at an increasing rate.

The slope of the lines informs us of the level of aggression. If, for example, both trend lines sloped upwards, but the bottom line was at a steeper angle than the top line, we can deduce that buyers are becoming more aggressive while the sellers are becoming less so.
 

Chart Patterns

Trend lines, like the ones above, create a bullish wedge pattern. There are many other patterns including head and shoulders, double tops/bottoms, triangles, and flags. These patterns also reflect the collective behavior of market participants as they react to changing market conditions.

For example, following a sustained uptrend, a head and shoulders pattern can be a warning. To help appreciate what the head and shoulders signal, imagine a stock trending higher and continually registering a series of higher highs and higher lows.  

The graph below shows the end of such an upward trend. The left shoulder (green) and head (yellow) will not distinguish themselves from the prior trend. But the right shoulder is the critical clue. It failed to hit a higher high. Either buyers are losing determination, or sellers are more resolved to sell. Either way, the behavior of market participants is changing.

A break below the prior support trend line, aka the neckline (black), would further support the theory that sellers are becoming relatively more aggressive, and the price could likely decline.

Inverse head shoulders, the opposite of that shown and described above, are bullish patterns.
 

Technical Indicators

Technical indicators are mathematical calculations applied to prices. Examples include movingaverages, relative strength index (RSI), and moving average convergence divergence (MACD).

For example, the relative strength index or RSI helps measure momentum. Momentum quantifies the relative aggressiveness of buyers and sellers. RSI measures the speed and magnitude of recent price changes over a certain period.

RSI computes the average of the daily gains and losses over a set period. It then indexes it on a scale of 0-100. Scores above 70 are considered overbought. In such a case, momentum is powerful but not easily sustainable. Conversely, under 30 is considered oversold and likely due to bounce.

As buyers become less aggressive in an uptrend or sellers become more assertive, the nature of daily price changes will change. The change may not be initially evident in price graphs, but indicators like RSI can pick up these subtle behavioral changes.

The graph below uses the above head and shoulders price data and applies a 14-day RSI. As shown, the RSI tends to peak and trough before the price.

We recommend using multiple indicators to help confirm what individual indicators signal.
 

Volume Analysis

Volume is an important data point used by technicians. Trend lines, patterns, and indicators are useless if there is little trading activity. Changes in volume help further confirm or refute what trend lines, patterns, and indicators are telling us.

For example, if we witness rising volume in a bullish pattern, we have further confirmation that buyers are getting relatively more aggressive than sellers.

It’s also critical to recognize that periods with high volumes represent a price range where many transactions have occurred. Therefore, those levels often become support or resistance levels.

Moreover, they help us quantify the profit and loss point of view of many market participants. Behavioral economics teaches us that investors tend to become irrational when losing money. If the price falls below a level at which high volumes occurred, a good number of investors are likely in the red. An aversion to losses may trigger irrational selling and put further downward pressure on prices.   
 

Summary

Naysayers can call technical analysts voodoo or magic or whatever they please. We could care less. Any bit of information we glean about the mindset of market participants is invaluable.

It’s important to restate that technical analysis alone cannot fully capture all the behavioral aspects of market participants, nor can it predict the future with certainty. When used with fundamental, macroeconomic, and liquidity analysis, technical analysis helps us form a complete picture of the state of markets and better make well-informed trading decisions.

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