tech analysis and EMH

Basically the market has a real component and a mass psychological component to it. Its important to realize that you can make money on either component if you understand it well enough (though you’d probably want some idea of how they interact). The fundamental view is that you can determine the true value of something by looking at balance sheet and other things and from there decide to buy or sell, and hope to make money when price conveges back to true value. This assumes several things, namely that your valuation model is correct, that prices oscillate around their true value and will revert there sometime, that the true value won’t somehow change in the interim, and that the market won’t stay “irrational” longer than you can stay solvent. Now, if you have a grip on the psychological factors, you can potentially make money, even if a security is trading at its fundamental value, which is something you can’t do with fundamental analysis. If you have a sense that people are overconfident, or about to panic, or are running from something else so that they arent thinking fully about where they are running to, you can make short or medium term price predictions that make money too. However, you do need to manage more than direction; you need to manage position sizes and stop losses effectively to stay in the game (as you do with fundamental analysis). But the psychological side of things is trickier than one thinks because it is a softer science, and that makes everyone rink that they can do it whether they are appropriately analytical/critical or not.

i see there are “Chief TA” at big institutions, so i suppose they have to add some type fo value.

The underlying logic of TA I’ve read is usually behavior. So if the price does this pattern, it’s because of X behavior, and if X behavior is occuring then I can make profitable predictions of future price. As an example, say the market makers know/suspect people have a bunch of stop loss orders put in at 30.00 per share of GE. If the current price is 30.20, they’ll short the hell out of the stock, and try to get it to hit that magical 30.00 level. If successful, the orders are tripped and the price temporarily plunges, giving them a short profit. Now the stock is “oversold,” they cover their shorts, perhaps go long, and the price rallies back to where it was before. Based on this example, you could logically assume the price would make some sort of predictable pattern. IE, if the stock price breaks through its support line, expect it to keep falling, then rebound back above. Profit taking after a rally, people continuing to buy realestate/dotcom stocks simply because the price keeps skyrocketing, people selling off a loser stock right as they break even again, etc… are other examples of behavioral price movements that potentially have a pattern to them.

I don’t know about the market-maker part. At least on the NYSE, a market maker running stops is frowned upon (he’s supposed to mitigate volatility not create it for his own advantage).

I think one important piece has been missing from this discussion. TA assumes that all the news in the world, including credit, turmoil, unemployment, recession, earnings, meteorite, and on is reflected in the current price of the security. Therefore, one need not try to digest all the news that will or will not come out. The price of the security is what it should be. AND, if the security is trending higher, then the fundamentals are getting stronger. If it is trending lower, the fundamentals are weak. Some may get lazy and say, well why do fundamental analysis if it’s already baked in the price of the stock? That’s wrong. There should have to be some confirming factors. Again, as JDV stated, it’s a tool, and whether it’s your hammer, or your nail, it’s another tool that can help you evaluate your purchase.

Oh boy… I barfed up a lot in this post… As for books, here are the most helpful things I’ve run across for Technical Analysis. Curtis Faith, “Way of the Turtle” - a discussion of the (once) famous Turtle Traders, who were the result of a bet between two traders about whether traders are born or made. The bet was settled as “good trading can be taught,” although the author feels that the psychological demands of trading suggest that at least part of the answer lies in psychological disposition which may be genetic. What’s good about this book is that it gets into the mentality of trading vs. investing and you get a sense of how the Turtle methodology differs from some of the other trading methodologies out there. It helps open your mind to alternate ways of playing the game that have a systematic component to them. Gerald Appel’s “Technical Analysis: Power Tools for Active Investors” goes into the logic of several technical indicators: moving averages, convergence-divergence indicators, etc… Appel puts it into a logical framework and explains what the different indicators are likely to be indicating. I believe some of it more than others, but it feels logical… it’s not just a discussion of what pattern follows what pattern. Alexander Elder’s “Come into my Trading Room.” This guy is absolutely amazing, and points out his three key points of successful trading: a disciplined mind (meaning that you don’t let your emotions get in the way of your analysis, which basically means having your exit conditions planned before you enter a position, and sticking to your plan (which should include stop-losses), skilled use of technical analysis (and fundamental analysis if you choose), and, perhaps most importantly, money management, which deals with position sizing and risk management. He also talks about how technical patterns tend to reflect a tug-of-war between investors who are bullish and investors who are bearish, and how psychologists link chart patterns to behavioral tendencies and biases. By the way, he is a practicing psychiatrist as well. I love this guy… his story is pretty interesting too, how he was a physician on a Soviet warship, and was running through the streets of Liberia (I think), chased by his shipmates as he ran to seek asylum in the US Embassy. He is such a smart, clear, interesting guy, I can’t stop saying great things about him. For example, Frank, you mentioned the converging triangle. The behavioral explanation for the converging triangle is that bulls are getting more optimistic and/or bears are getting less optimistic. Whatever is happening to bulls and bears is affecting on one side faster than the other. The line defining the top of the triangle represents the price where bears overpower bulls and send the price downwards. The line defining the bottom represents the price where bullish sentiment overpowers the bears and sends the price upwards again. At some point, if the tendency continues, one side of the market will be so bullish or bearish that it will overpower the other entirely, and a new trend or pattern will be produced. You’re not 100% sure what way it will go (often the pattern preceding the triangle continues, and you can also get some hints by the relative slope of the sides of the triangle, to get a sense of who’s getting optimistic or pessimistic faster). The thing about converging triangles is that they pretty much must end at some point, and that is where you place your bets to see what pattern may be coming next. Now, random walks may have things that look like triangles too, so who’s to say that this triangle isn’t completely random. But here’s the thing. If you think that this psychological explanation makes sense, then it’s very likely that there are more triangles happening because of market psychology than by brownian diffusion. If you have a random triangle, you’ll still win 50 % of the time you place a bet based on this. But if you think that the psychological explanation makes sense, then at least some of them are behaving non-randomly, and that can push your win/loss ratio to 51% or more. Now you have a positive sum game, and with proper money management, you may actually get somewhere.

so TA assumes efficient markets? i better brush up on my fundamentals then.

Something else to remember. 10 different people can look at the same chart and see 10 different things. The bottom line is that it won’t tell you tomorrow’s price, and it can never be 100% accurate. But knowing TA gives a trader an advantage, and at the least, may pick out better entry and exit stops. There are a million ways to make money in the markets. If you are a fundamentalist, then TA can help confirm your analysis.

bchadwick; Thanks for the book info. I just added three of Elder’s books into my cart at Amazon and look forward to the interesting reads.