The older I get, the more I rely on technical analysis. Let’s take a hypothetical example of some payroll number coming out. The number comes out strong, you expect the stock market to puke, and it does… at first. But then it rips higher into the close.
How could you have possibly predicted something like that happening? This is what makes markets so hard. Well, to be honest, since there is no fundamental reason for that to happen, fundamentals aren’t going to be of any help. And sentiment is good for catching long-term trends but isn’t very useful in the micro term.
You have to rely on the charts. The charts will tell you what is going to happen.
Now, there are more charting techniques than you can shake a stick at. There are support and resistance lines, head-and-shoulders, MACD, oscillators, Demark, Gann Angles, Elliott Wave—the point here is that I don’t really care what you use, as long as it works for you.
Some people even use astrology to predict the markets. I tend to think that is a little hokey, but again, if it works for you, do it.
Five years ago, I would have said that my trading style was as follows:
80% sentiment
20% technical
0% fundamental
Now, I would say it looks like this:
40% sentiment
60% technical
0% fundamental
Because oftentimes, technicals and sentiment are the same thing. Sentiment tells you when people are extremely bullish or bearish on something. Technicals will tell you the same thing—just look at the chart!
Right now, people are very bearish on bonds. My sentiment Spidey senses tell me that sometime soon, we are going to have a reversal in bonds, and yields are going to go lower.
But sentiment is difficult to quantify, and if you are trading, you need a more precise entry point. Sometimes sentiment does give you a precise entry point, but oftentimes, it doesn’t. You need to rely on the charts.
Not enough attention is paid to the importance of entry points when trading…
Let’s say a stock is trading at $20. You dawdle on it, you take your time researching it, and by the time you get around to buying it, it’s at $23. So, you buy it at $23. Then it goes down to $18. You are down about 25% on your investment. At this point, you’re thinking about puking it. But if you had bought it at $20, you would only be down 10%, and you might even be thinking about adding to the position.
This is why entry points are so important—because of anchoring. We all focus on the price that we bought a stock at, and we hope that we will get back to even. Cognitive biases are a subject for another newsletter, but let’s just say that the price at where you bought a stock is completely irrelevant—what is important is what you think of the stock right now.
I like for my entry points to be very, very precise, and the reason for that is that I never want to take any pain. I don’t like drawdowns, and neither do you. Drawdowns mess with your psychology. When you are in a drawdown, it is difficult to focus on anything else. It commands all your attention.
There is a saying about how we all trade actual capital, but we also trade emotional capital. If your entry point on a stock is bad, you sustain a drawdown, and you get to the point where you really think you should add to the position (where it has absolutely bottomed)—well, if you’ve lost a lot of your emotional capital, you won’t be able to do it. You want to be dealing from a position of strength, rather than a position of weakness.
If you’re wondering where to get started with technical analysis, there is only one book that you need: Technical Analysis of the Financial Markets by John Murphy.
It’s really an encyclopedia of charting techniques and tells you how to use them. If you want to learn more about a particular charting technique, you can dig a little deeper with some other books.
I’m always shocked how many professional traders don’t even know about the existence of the Murphy book, let alone use it. It’s a classic. I used it to develop my charting techniques in the mid-2000s.
The market efficiency bros will tell you that the markets are efficient and none of this stuff matters—it is already priced in. That assumes there are an infinite amount of people looking at an infinite amount of charting techniques on a stock, but that isn’t true.
If you have some arcane way of looking at a chart that gives you an edge—that nobody else is doing—you have exploited a market inefficiency. There are a lot of people out there who make money with technical analysis. Some of them are quite good. Try to have an open mind.
Jared Dillian, MFA
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