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Technical Analysis Is for the Birds

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This week, a major firm announced plans to lay off its technical analysts. On CNBC, Art Cashin referred to "cocktail-napkin technical analysts."

Who can blame them after watching trading patterns the last few years? During periods over the last three years, technical analysts themselves might have termed technical analysis for the birds. Perhaps they might have even employed stronger language to express the same sentiment. Supposedly reliable formations proved anything but reliable.

Daily Chart of the OEX, 2003:


 

Daily OEX Chart, 2005:


 

Thirty-Minute Chart of the NDX, September 2004


 

The three charts above exemplify situations in which prices broke in a direction counter to that predicted by the formation. Why bother with technical analysis? Why not rely solely on fundamental analysis?

There's the obvious reason. Despite the impression given by its failures, technical analysis often does work.

Fifteen-Minute Chart of G:


 

Thirty-Minute Chart of the TRAN


 

Another obvious point exists. No formation proves 100 percent reliable, and we should expect failures. Market guru Pring deems head-and-shoulders pattern one of the most reliable of all chart formations, but he cautions that a neckline break must be decisive if the formation is considered confirmed. He mentions cases of H&S failures, in which the neckline is never breached or breached only briefly before a reversal back through the neckline. Such H&S failures often result in strong rallies, but Pring prefaces even this outcome with the modifier "usually." Perhaps, as we've educated ourselves on different aspects of technical analysis, learning to recognize chart patterns and formations, we've set our expectations too high. Just because we recognize a pattern doesn't mean we should forget to apply the word "potential" to the outcome.

Perhaps. But you'll still have difficulty convincing those who traded through the spring of 2003 or the choppy pullback in the first quarter of 2004 that their expectations were too high. During the spring of 2003, bearish chart developments most often resolved to the upside even when volume considerations, bearish divergences and other signals corroborated the bearishness of the formations. During that period, "faith" trading, trading when play participants had faith that the markets would move higher even in the face of formations opposing their views, appeared to be as good a tactic as studying technical analysis.

That wasn't true in the directionless first quarter of 2004, however. Neither faith traders nor technical traders fared particularly well. Choppy markets chopped both types into uniform small bits. Setups often saw confirmation in the expected direction but failed to follow through and soon reversed. During that period, battling bearish and bullish formations could be discovered, with biased bulls and bears both finding plenty of evidence to support a trade their preferred direction, seducing the unwary into plays doomed to see a quick reversal.

So what's to be concluded? Sometimes technical analysis works and sometimes it doesn't? That's one conclusion, but a technical analyst could also argue that as much is to be learned from technical analysis failures as from setups that work well. Go back to Pring's example of a failed H&S pattern. One can be found on the SMH's 30-minute chart.

Annotated 30-Minute Chart of the SMH:


 

Given the fact that failures remain inevitable, no matter how good the setup, this one worked just as would be expected, with an explosive gain. Bears were alerted that bullish fervor remained strong enough to absorb supply. The get-in and get-out points provided were clear-cut. Technical analysis did in fact work.

It did in the spring of 2003, too. Repeated instances of failed bearish formations alerted bears that markets had an underpinning that was not going to let markets decline. Technical analysis worked during that choppy period in early 2004, too, at least as long as traders heeded the signals given and did not insist on always being in the market.

Annotated 15-Minute Chart of the SMH, January, 2003:


 

Formations broke apart before completing. Regular H&S's and inverse ones formed side by side. While none of these formations performed as might be expected, the accumulated evidence from their failures demonstrated the disorganization in the markets. Technical analysis worked. While it might have been possible to enter at least one profitable trade here, the accumulated evidence warned traders to beware the choppy conditions. Experienced traders would have known to step aside until a clearer pattern asserted itself. Until technical analysis worked in the expected way.

Whether in the expected way or not, technical analysis does work and serve as a beneficial adjunct to fundamental analysis. Sometimes technical analysis reveals a disorganization or something unexpected occurring, warning traders to step aside. Sometimes formations set up just as expected, confirm in the direction expected, and meet the expected targets. Technical analysis is for the birds: wise birds better known as owls.

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