Opening Position
September 2010
The use of charts has always been central to technical analysis. And in spite of referring to technical analysis in derisive terms such as “voodoo” and “hocus-pocus,” fundamental analysts do use charts (no matter how grudgingly). However, their use of charts may be limited to studying historical and current price movement. The technical analyst, however, takes it a few steps further, using past price behavior to determine the likelihood of future price movement.
Although examining a chart to determine future price movement can, in some respects, invite similarities to reading tea leaves or palms to foretell someone’s future, what many fail to realize is the amount of analysis that goes into interpreting price charts. There’s more than meets the eye when it comes to analyzing charts. Behind every price bar is a reflection of the behavior of market participants during a specific time period. It is this behavior that drives price movement in the markets. Although chart patterns may have unusual and sometimes humorous names such as cup & handle, head & shoulders, dumpling tops, or dead cat bounce, they all reveal some type of human behavior of traders. Human behavior never changes, and that is where technical analysis gains superiority over its counterpart. The fundamentals of a company can always change. Look at what happened to BP.
When it comes to anticipating the future performance of the markets, there is no right or wrong answer. Whichever type of analysis you opt for, you’re never going to be 100% correct. The advantage of using charts, if you know how to correctly analyze them, is that they are powerful visual tools and they can be interpreted relatively quickly. You don’t need to wait for analyst ratings on a company; you don’t need to wait for quarterly reports to be released; nor do you need to wait for news releases. Charts are based on a very simple premise: When there are more buyers than sellers, prices trend up. When there are more sellers than buyers, prices trend down. It’s when they reverse from an up or down move that matters tend to get a little more complicated.
These reversal points reflect a change in the ratio of buyers and sellers. Once you understand the mentality or sentiment of the crowds during these turning points, you can consider yourself an elite chartist. Understanding the behavior of market participants behind every price bar can keep you abreast of what is going on in the markets and help improve the timing of your entries and exits.
Jayanthi Gopalakrishnan, Editor