Monday, February 26, 2007

On Technical Analysis

A poster has asked the very legitimate question of why do I use technical analysis.

I struggled for a long time with this question myself. However, it wasn't until I read some of the older classic trader's books that I really started to understand how it works. The works of Gann, Schabacker and Gartley-- especially Gartley-- were incredibly enlightening. First, none of these traders used TA exclusively; they used it as part of an overall strategy. For example, in one book written in the 1930s, Gann spends a great deal of time talking about what industries will start to boom in the 1940s. He would combine these observations with TA to determine when to buy. All of these traders clearly stated many times that TA was not the hold grail and that the markets would do everything they could to make a fool of you. In other words, always be prepared to be wrong.

What I found confusing was the inclusion of a large number of indicators -- RSI, Stochastics, MACD etc.... These more modern ideas were really more statistical noise to me then helpful indicators. That's one of the reasons I almost never use them. I like to know where prices are now, where they have been. how many people are buying and selling (volume) and what the general trends are (simple moving averages). These basic data points are often all any trader really needs to know.

That being said, TA is not a holy grail of analysis. It can increase the probability of success. It is not a guarantor of success. In fact, no form of analysis is perfect. I've seen companies that were fundamentally undervalued languish at low prices for years despite the fact they were undervalued.

So here's the point.

1.) TA can help you figure out where prices have a higher probabilty of going.

2.) TA can tell you when it's a better time to buy.

3.) The markets can hand you your ass at a moments notice.