Technical Analysis & Behavioral Investing
Historically, chart watching can be traced back to over 200 years when Japanese rice traders used similar methods. In today’s day and age, Charles Dow is considered to be the father of Technical Analysis in its present form. In the olden days, the analysis was done manually using pencils and paper. The advent of computing technology has been a boon for the purveyors of Technical Analysis.
Technical Analysis (TA) of stock markets has gained in popularity over the years. The use of TA is now widespread to the extent that many a time we have commentators describing price action as ‘purely technical’. E
What is Technical Analysis?
Technical Analysis is based solely on data that is generated by the market which in turn is a function of the market participants. The premise is that humans will act in a manner that mirrors their past behaviour when faced with the same conditions. Indirectly, technical analysis encompasses a study of multiple facets of human behaviour that are intertwined with each other viz. crowd psychology, herd mentality, probability analyses, greed, fear, supply and demand.
What is a Chart?
A picture is worth a thousand words, and in the investing world, that translates into a thousand days or weeks of data. The chart summarises all the trading for the selected period. Once these summaries are plotted together, trends and patterns are formed and are visible to the astute reader of the chart. The chart reveals where the stock is and how it got there. Just by looking at where the stock is trading is useless, adding some perspective of where it was trading last month or last year helps.
Types of Charts
Broadly there are two types of charts. These are:
- Bar Charts, these summarise a trading period. A trading period can be ten minutes, a day, a week, a month or a couple of years. The daily and weekly charts are the most popular ones. At times, the shorter duration charts aren’t indicative enough from an analytical point of view. At such times one may prefer to look at charts that incorporate longer time frames. In other words, when in doubt (about a chart pattern), it helps to zoom out (expand the time horizon.
- Line Charts connect the closing prices to form a line.
Technical Analysis & Behavioral Investing
When we trade the markets, we are trying to do one of three things. Either we want to buy, to sell or do nothing. Once we have decided on which course of action to take, the trillion dollar question in everyone’s minds is whether the market will agree with us. In other words, we have to compare our predictions about the price action with what the market does. Media outlets and news channels spend a considerable amount of time and effort in describing what the market did the previous day. Most of us who track the financial news tend to think that the price action in the market follows the news. Unfortunately, we’ve got that backwards. More often than not, the news cycle follows the price action that took place the previous day, and not the other way round.
While listening to the analysis, the figure of speech is something like this: ’the market did not like the economic data, or the market went down because.. and so on. Nobody asks the simple question: who or what is the market? Is ’the market’ a living, breathing thing? In reality, the market is just the sum of the actions (trades) of all the participants; there is no one single guiding force, nor is there any predetermined agenda to move in the direction that it does. In other words, the mélange of emotions that are generated by the crowd of human beings (market participants) reflects in the demand and supply dynamics for a particular stock.
Just as in any other market, in the stock market as well, the demand and supply for a stock determine the price at which it will trade. The market by definition is the collective price action of the shares comprised therein. In other words, crowd psychology is what determines price discovery in every market, and the stock market is not an exception. What the charts do is to display information in a graphical form making it easy to spot trends and patterns. The charts reveal the behaviour of the crowd.
The next question is: so what if the charts reveal the behaviour of the crowd? The answer lies in understanding how chart patterns are formed. Embedded within the chart patterns are the buying and selling actions of the participants. Human beings tend to act similarly when faced with an identical situation. And Chart Patterns are the closest manifestations of those identical situations. Since human beings have inconsistent behaviours, so do charts. Ergo, Technical Analysis as a tool does not work 100 per cent of the time.
Definitions of key terms from a behavioural standpoint
Technical Analysis is based solely on data that is generated by market participants. Unlike economic data, this data is not revised over time. Chart watchers make educated guesses based on the data that they analyse. Any analytical mistakes made by chartists are not a reflection on the science of Technical Analysis; they reflect a failure in the charting or analytical ability of the person concerned.
Technical Analysis focuses on how stock prices are moving and how powerful these moves are. Price and volume are used to measure supply and demand. Collectively supply and demand result in price discovery. Technical Analysis or Charting depicts the historical behaviour of the crowd and mirrors the changes in the perceptions of the market participants. The intrinsic values of the underlying businesses do not change in real-time; what these businesses are perceived to be worth does change continuously. Supply and demand for a stock are generated by what people perceive as the future value of the business. Effectively, the stock market represents the combined perceptions of thousands of human beings responding to information, misinformation, and whim. In other words, perceptions matter and charts show us where and how perceptions meet reality. The chart shows us what is happening and how it came to be. From this, we can infer how things will pan out in the future. What Technical Analysis helps us to do is to improve the probabilities (risk-reward ratio) of guessing future outcomes. Technical Analysis is not the ‘holy grail’ and in the world investing there isn’t one. Technical Analysis is one of the tools in the arsenal of the Behavioral Investor. The others are a knowledge of the business, position sizing etc. Technical Analysis can help us in determining when to buy or sell a stock. Since Technical Analysis is based on crowd psychology, the existence of a crowd is imperative. In other words, it wouldn’t work nearly as well when the traded volumes are low. What constitutes a low or high traded volume is subjective, but one has to factor the liquidity or the lack of it when using charting tools. Almost all the terms used by chartists are based on the way traders behave. The following will make things crystal clear.
- Many commentators use the analogy of a three-legged stool for describing Technical Analysis. Price is the top of the stool. Volume, Time and Sentiment are the three legs that support the top of the table; they do not supplant it. Of these, volume and time can be defined and measured accurately. The third leg viz sentiment is the oddball in the analysis and cannot be quantified, gauged or measured. Since sentiment is known to be notoriously fickle, changes in sentiment are synonymous with a rise in volatility.
- What is the trend? To give a fishing analogy, think of a school of fish. If the fish on the right side of the school, see a shark, they will veer to the left. It’ll cause a ripple effect throughout the school, and even though the fish on the left side of the school hasn’t seen the shark, they start to veer to the left. Information about the presence of the shark propagates throughout the school causing a discernible shift in the direction of the school – ditto for the stock market. Information about a company creates a similar move in the market and its called a trend. By analysing a chart for a stock or an Index, we are trying to identify the direction of the primary trend. Is it up down or sideways?
- A trend is a market in motion and constitutes a somewhat consistent change in price levels over time. Some trends are smooth; some tend to wiggle and have pullbacks. What matters is the direction of the primary trend. The wiggles constitute volatility, but as long as the primary trend ‘holds’, so does the direction of the prices that follow.
- All trends stay in motion until an outside force (sight of a shark) acts upon them. An imperfect flow of information (seeing a shark when there is none) can cause a change in the direction of the primary trend.
- A pattern is a market at rest, deciding whether it wants to continue in the trend or change course. A continuation pattern is formed when prices pause in an ongoing trend. When prices reverse in a current trend, it’s called a reversal pattern. When traders are undecided and have no clue on which way they want to trade, its called a directionless or a sideways pattern. Chart patterns help us decide on our strategy based on the subjective probabilities of the data contained in therein. Once the pattern is broken, the chances of decisive price action occurring are higher than they otherwise would’ve been. Here again, most of us have got things backwards. Patterns break because the crowd decided it was time to move; it’s not that the other way round as is commonly believed.
- Resistance and Support for a stock are the tops and bottoms of the pattern. Like everything else, resistance and support for a stock are manifestations of the supply and demand for the name. Resistance slows or stops a trend; support holds the market from falling further albeit temporarily. In other words, it is supply and demand. When prices approach resistance, sellers become aggressive since they feel that prices have become expensive. It leads to an increase in the supply function – vice-versa for support. What looks expensive at resistance is now cheap at support, and it leads to a rise in the demand function. At resistance or support levels, when demand exceeds supply or vice-versa, the stock will tend to move higher or lower as the case may be. These excesses cause ‘breakouts’ or ‘breakdowns’ and may result in the continuation of the primary trend or the start of a new trend in the opposite direction.
