Technical analysis of chart patterns is so popular today, it’s hard to remember the scorn heaped on it by my professors at business school. This condescending remark is from Benoit Mandelbrot. Yes, the same Mandelbrot who discovered fractal scaling.
The newspapers’ financial pages are filled with … self-styled “chartists,” who plot the past suitably and proclaim they can predict the future from those charts’ geometry.
Technical analysis does not claim to predict the future, but it does allow us to make conditional statements and asymmetrical bets. A conditional statement is, “once price breaks $52, it will probably run to $55.” On the other hand, if it’s a false breakout, we’ll know by $51 and exit with a small loss.
If you can be right 50% of the time, with a 3 to 1 payoff, then you are a successful trader. Likewise, if you can find 1 to 1 bets with greater than 50% accuracy. These bets are asymmetrical because they have an expected value greater than zero. Books by John Carter and Marcel Link are full of them.
Win $3 x 50% + Lose $1 x 50% = Win $1 (per average trade)
Technical analysis can find these situations using patterns based on market psychology. That may sound like voodoo magic. A better expression might be, attention to where other traders are positioned, and what their strategies are likely to be. For an example, consider the venerable “line of resistance.”
Below is a chart of Amerisource Bergen, on which I have placed a horizontal line at $77.50. This line held, as resistance, for three months. After two attempts to break the line in late July, and then a discouraging August, bulls begin to suspect $77.50 is the best price they’re ever going to get. On the next attempt, in September, they’re ready to sell.
Throughout September and into August, investors who want the stock may buy it on dips, but they know not to pay more than $77.50. Investors who want out, having bought below $72, are happy with this price. Traders can rely on shorting the stock here, with a stop loss at $78 and a price target of $76. A consensus has formed, with “selling pressure” holding the line firm.
This pretty much explains why resistance lines are real (and not voodoo). The line may slope upward, as buyers gradually become willing to pay more for the stock. There are also support lines, which rely on the same psychology.
While we’re at it, let’s look at what happens when price finally breaks through resistance. Sellers are happy, obviously, but who’s buying? The bears. All the traders who were short from $77.50, plus some poor fools who went short after October 12, must now buy to cover their losses.
As October 27 opens, no one who owns the stock has ever paid more than $77.50. This range is a wilderness of stop loss orders from the shorts, and stop entry orders from the breakout traders. Price will move rapidly through such an area, which is why the latter group is waiting here. Price jumps to $79 and then pauses for the earnings report due October 29.
I like to think of resistance as standing out from the chart, like a ridge on a topographic map. As price moves toward resistance or support, it travels “up” this third dimension. Price generally rolls back the way it came. Once over the ridge, however, it will roll onward rapidly.
This is why Jesse Livermore speaks of pivotal points generally, whether they are above or below the current price. Price may also flow in a channel, like a valley on the chart. I think this topographical metaphor is a good one, and I hope I demystified something, too.