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Regular readers know that I’m a big chart guy. And I’ve spent a great deal of time getting to know and understand how analyzing stock charts work.
But technical analysis was around way before I got my start in the financial markets.
Centuries of work interpreting and understanding the movement of prices in financial markets brings us to today’s technical analysis.
Marks on paper, calculations by hand, pit traders and runners have all given way to the speed and efficiency of computers and electronic information networks.
Yet the goals remain the same…
- Identify the trend as early as possible
- Capitalize on it for as long as possible
- Manage the risks along the way
Technical analysis is based on one major assumption… Freely traded market prices, in general, travel in trends.
Based on this assumption, traders and investors hope to buy a stock at the beginning of an upward trend at a low price, ride the trend and sell the stock when the trend ends at a higher price.
Although this strategy sounds simple, implementing it is exceedingly complex.
Choose Your Trend
Trends of different lengths tend to have the same characteristics.
In other words, a trend in annual data will behave the same as a trend in five-minute data.
Traders must choose which trend is most important for them based on their investment objectives, their personal preferences and the amount of time they can devote to watching market prices.
One trader might be more concerned about the business cycle trend that occurs over several years.
Another trader might be more concerned about the trend over the next six months.
And a third trader might be most concerned about the intraday trend.
Although traders have investment time horizons that vary greatly, they can use the same basic methods of analyzing trends because of the commonalities that exist among trends of different lengths.
Obvious in Hindsight
But ideally, we would like to spot a new trend at its beginning, buy, and then spot its end and sell.
However, this almost never happens.
Those searching for a method of pinpointing the precise high and low will end up sorely disappointed… and likely broke.
There is always a risk of spotting a trend too late and missing potential profit… Or not identifying when the party is over and holding a stock well past its price peak.
On the other hand, if the trader thinks the trend has ended before it really has and sells the security prematurely, they have then given up potential profits.
Thus, the technical analyst expends a lot of time and brainpower attempting to spot as early as possible when a trend is beginning and ending.
This is the reason for studying charts, moving averages, oscillators, support, resistance and all the other techniques.
Efficient Market Fairy Tale
The fact that market prices trend has been known for thousands of years.
However, academics dispute the idea that markets have a tendency to trend because, if it were true, it would spoil their theoretical models.
But we know these models are flawed.
You see, I was taught the “efficient markets hypothesis” in college. Even as an undergrad, I knew the concept didn’t hold water.
Academics cling to the concept, unwilling to accept the enormous amount of evidence against it.
If investment success were truly random, there would be no Warren Buffett… no Paul Tudor Jones… no John Paulson… and no David Tepper.
Traditionalists love to scorn technical analysis as if it were a cult.
But these are merely the ramblings of those incapable of doing it – those who settle for 8%-10% a year and comfort themselves with the faulty belief that outperformance is not possible.
Technical analysis works.
It has worked for more than 100 years as evidenced by the success of early stock market operators like the great Jesse Livermore.
It was developed through practical experience of real traders trading real markets – not academic models.
Sizable fortunes have been built by those who adhere to its principles…
Which is why I teach technical analysis to all of my students.
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Embrace the surge,
Editor, Stock Surge Daily